Tax planning: Timing pension contributions brings tax relief to the rescue

Paying into a pension within a particular time frame can bring significant savings, writes James Hay's Graeme Robb.

John headed home from the pub quiz disappointed. His team had lost by one point and he still couldn’t believe that he had got the question wrong. He replayed it in his mind ‘What was The Beatles’ last UK Number One single?’ (Answer at bottom of article!).

John had incorrectly thought it was ‘The Long & Winding Road’. His team mates relied on him for questions like this. He could recite song lyrics from bands across five decades, quote swathes of dialogue from his favourite movies but his real passion was old TV series from The Generation Game to The Young Ones, from Bilko to Blackadder.

When he got home, John was surprised to find his pristine limited edition model of Thunderbird 2 sitting on the table, still in its original packaging. His wife had been up in the attic! And worryingly she had a proposal for him.

Pension rescue plan

‘I have been looking on eBay,’ she said, ‘and I think we could sell this toy for £500. It’s just sitting gathering dust in the attic and the proceeds will pay some of your pension contribution for you.’ The pension contribution she was referring to was a proposed payment of £2,600 into his pension fund.

John, who is now 47, left his previous job two years ago when in a moment of boredom he fired an elastic band across the office and took out the eye of the sales director. His previous employer operated a final salary pension scheme. His new company pension is less generous, however, and John therefore took out a personal pension to top it up.

John has been concerned that his regular contributions might be insufficient and after a meeting with Dino Paparelli, his IFA, he is considering the payment of a lump sum contribution of £2,600.

John is a higher rate taxpayer earning £44,085. His employer, Big-Appetito, makes ready made meals and has been experiencing a drop in sales as more and more families turn to home cooking as the recession bites. Against this backdrop, the company has advised employees that there is to be a salary freeze for the foreseeable future.

Thunderbird 2 cannot go!

After going to bed, John had a troubled sleep. He awoke in the night with a fever, horrified at his wife’s suggestion. After all, Virgil Tracy piloted Thunderbird 2 and Virgil had always been his favourite Thunderbirds character. Indeed that had been his nickname at school as he bore an uncanny resemblance. For once, John was determined to defy his wife.

He therefore got up in the dead of night, put on his favourite cardigan over his pyjamas and started to do some calculations. He wrote:

It is currently tax year 2008/09, and the following figures are relevant: 

• Earnings £44,085
• Pension contribution £2,600
• Personal allowance £6,035
• Basic rate band £34,800
• Starting point for higher rate tax £40,835 (£6,035+£34,800)
• I have £3,250 of income subject to higher rate tax (£44,085-£40,835)

If I pay a pension contribution of £2,600 then this is multiplied by 100/80 to give a gross contribution of £3,250 – so that’s why Dino suggested a contribution of £2,600!

I get immediate relief of £650 thanks to my pension provider reclaiming this amount from HMRC.

I will also get higher rate tax relief by extending my basic rate band by £3,250. This means that none of my income is subject to higher rate tax giving additional relief of £3,250 @ 20% = £650.

A different rescue strategy

John then decided to calculate the tax relief available to him should he pay his contribution after 5 April 2009 and wrote:

If I pay my contribution in the tax year 2009/10 the following figures are relevant: 

• Earnings £44,085
• Pension contribution £2,600
• Personal allowance £6,475
• Basic rate band £37,400
• Starting point for higher rate tax £43,875 (£6,475+£37,400)
• I have £210 of income subject to higher rate tax (£44,085-£43,875)

If I pay a pension contribution of £2,600 then this is multiplied by 100/80 to give a gross contribution of £3,250. Therefore I get immediate relief of £650 thanks to my pension provider reclaiming £650 from HMRC.

I will also get higher rate tax relief by extending my basic rate band. It only needs to be extended by £210 to ensure that none of my income is subject to higher rate tax giving additional relief of £210 @ 20% = £42.

John then summarised his position as follows: 

• Pension contribution paid 2008/09
• Immediate relief (reclaimed by provider) £650
• Higher rate tax relief £650
• Pension contribution paid 2009/10
• Immediate relief (reclaimed by provider) £650
• Higher rate tax relief £42
• Tax saved if contribution paid 2008/09 = £608

Checking in with Brains

Later that day, John called his IFA to check his calculations. It seemed strange that a pension contribution paid before 6 April 2009 would save him £608 rather than an identical contribution paid after 5 April 2010. Dino confirmed that he was indeed correct and that a tax saving of £608 is exactly achievable by anyone in the following position:  

• At least £3,040 of income subject to higher rate tax in 2008/09.
• Willing to pay a pension contribution sufficient to wipe out that 2008/09 higher rate tax liability.
• Income will not rise in 2009/10 (if income set to rise in 2009/10 then a 2008/09 contribution will still deliver greater tax relief unless income is set to rise by more than £3,040).

‘Darling,’ shouted John to his wife, ‘we don’t need to sell Thunderbird 2, I have a cunning plan...’ 

Answer to pub quiz: Ballad of John & Yoko; June 1969 for three weeks.

Graeme Robb is technical manager at James Hay, part of Santander Private Banking Global Division.