How your pension can save you from paying in a higher tax bracket

While a promotion or new role often comes with the benefit of extra money in your pocket, you may be surprised when you receive your first pay check by how much of that extra income has been gobbled up by tax.

This is especially true when that new role pops you into a higher tax bracket, and suddenly, some of your income is being taxed at a rate of 40% or 45%. But by being savvy with your pension contributions, you may be able to avoid paying into the higher tax bracket at all.

Currently, there is a tax-free income allowance of £12,570 per year, and then earnings are taxed at the basic 20% rate up to £50,270 per year. Once you breach this income level, the tax rates steepen quickly, with earnings exceeding £50,270 taxed at 40% per year. Tax on the slice of earnings over £125,140 rises slightly to a rate of 45%. The tax rates and banks for Scotland are different to the rest of the UK.

If you’re right on the brink of these tax bands, these rate changes can eat away at a good portion of that salary increase. But by upping your pension contributions, you can bring your income down below this limit, while still receiving tax relief through your pension.

The typical minimum amount for your personal contribution when you are auto-enrolled in a pension is 5%, including tax relief. If you have a £65,000 salary, that will equate to a total of £3,250. This would mean that you still have £11,480 in that higher tax bracket, and after 40% tax the take home from that is just £6,888.

However, if you had a £65,000 salary and upped your pension contribution to 10%, you’d be putting £6,500 in your pension, and you'd be left with £8,230 in the higher tax bracket, that would become £4,938 post tax. You’d be down less than £2,000 in your yearly take home pay, and you would be doubling what you put in your pension, without even factoring in a possible rise of employer contribution.

Types of tax relief through your pension

There are three main payments that will be coming out of your salary before you receive the amount you take home, including income tax, National Insurance, and pension payments. Depending on what kind of pension plan you have, your pension may come out first, second, or third. You can ask your employer or your provider to determine how your pension works.

Your pension may be paid into after your National Insurance payment, but before your income tax is taken, through a system called ‘net pay’. Because your contribution is taken before tax, you automatically get tax relief on the contribution(s).

If your pension payment is collected after both your National Insurance contribution and income tax is taken out, this is called ‘relief at source’. A lower amount is taken from your pay after tax, and the pension scheme reclaims basic rate (20%) tax relief for you automatically from HMRC. So, you’ll still end up with the same total pension contribution as through net pay.

If you have income above the basic tax bracket, you can get additional tax relief of 20% for income above the £50,270, and 25% above the £125,140. However, you must file this with the HMRC, or else you will not receive any additional relief. This relief won’t be paid into your pension, it will just come out of future tax bills.

Using salary sacrifice

The disadvantage of the relief at source and net pay systems is that you aren’t receiving a reimbursement for your National Insurance payment on your pension, even though that amount is being paid out before your pension.

However, if your pension instead uses salary sacrifice, you can make your pension payment before there’s any other interference from National Insurance or income tax.

Salary sacrifice is when you make an agreement with your employer to give up a portion of your salary in return for a benefit. In this case, it means giving up a portion of your salary for a pension contribution.

The main benefit to you of salary sacrifice comes from National Insurance not eating into your contributions. It is important to note, however, that this on paper looks like a cut to your salary, which could be important when it comes to things like being approved for a mortgage.

How does salary sacrifice work?

Let’s say a new employee, Beth, has been offered by her employer to use a salary sacrifice scheme. She earns £55,000 and has opted to up her personal contribution to 10%. This means that she is contributing £5,500 per year to her salary, leaving her with £49,500.

Because £49,500 is under the higher tax bracket, she will now pay tax of 20% on her entire income. Factoring in her annual tax-free income allowance of £12,570, this means she is paying £7,386 in income tax. She will also pay National Insurance of £2,953. Taking away the income tax and National Insurance from that £49,500, she would have a take home pay of £39,161, in addition to her pension contribution of £5,500.

Now, let’s say Beth opted out of salary sacrifice, and is instead in a net pay scheme. From her £55,000 salary, National Insurance of £3,394 will be taken, as well as a pension contribution of £5,500 before tax. From this amount, she will still need to pay her income tax of £7,386 like with salary sacrifice. This leaves her take home pay at £38,720.