I am drawing a final salary pension and the state pension. Very soon, the total of these will take me over £100,000 in annual income when I will start to lose my annual personal allowance of £12,570 and my effective tax rate will be 60%. 

I have minimised other income outside of ISAs, i.e. dividends from shares and interest from savings. So, I am looking at ways to stay below £100,000. 

From reading AJ Bell articles, it appears my options would be:

1. To invest in EIS and VCTs, and/or  

2. Make pension contributions in a SIPP, as I have 5.66% remaining from my Fixed Protection 2014 LTA. I am not clear if I can do this as I do not have any earned income. However, I understand that everyone is allowed to make pension contributions of £3,600 gross annually. 

I appreciate your help.

Nat

Rachel Vahey,  AJ Bell Head of Public Policy, says:

One of the more unfortunate ‘kinks’ in the UK tax system is how taxation works for those people whose income is in excess of £100,000.

Once your income hits this figure, you’ll start to lose the tax-free personal allowance (currently frozen at £12,570) at a rate of £1 for every £2 of income above the threshold.

By the time your income reaches £125,140 it’s completely gone, meaning as you say you will pay an effective tax rate of 60% on the band of earnings between £100,000 and £125,140.

Fortunately, there are several steps those in this position can take to avoid this tax hike.

You can maximise your tax-free allowances, such as ISAs. Or if you have filled up your own allowances you could transfer investments to a spouse to use up their allowances or, if they fall within a lower tax bracket, they could pay tax at a lower rate.

Any income you generate within an ISA is completely tax free, and you can pay in up to £20,000 a year.

‘Bed & ISA’ involves selling an investment, using the proceeds to make an ISA payment, and then repurchasing the investment within the ISA.

However, you need to be aware selling investments outside an ISA may realise a capital gain which will be taxed if it is above your annual exempt amount of £3,000.

Another option is paying in pension contributions, which effectively reduces your taxable income and could help bring your income back under the £100,000 threshold, avoiding the 60% tax trap, but there are several things to consider.

The annual allowance is set at £60,000 and covers total contributions from both the employer and the individual, as well as tax relief.

This annual allowance falls to £10,000 if someone has flexibly accessed their pension pot, usually by taking a taxed income from drawdown.

If, for example, you have only taken a tax-free cash lump sum and left the rest untouched in drawdown, or you have bought an annuity or are receiving a defined benefit pension, then you get to keep the higher £60,000 allowance.

However, there is another limit for personal contributions of 100% of your UK earnings. If you have no earnings then you can still contribute to a pension – up to £2,880, which is £3,600 once you add in pension tax relief.

Keep in mind pension contributions don’t receive tax relief after you turn 75, so many providers won’t accept them from that point.

The lifetime allowance has now been completely abolished from pensions, yet it still manages to cast a shadow in some areas.

We now have two new limits. The lump sum allowance is usually set at £268,275 and covers the tax-free lump sum someone receives in their life.

The lump sum and death benefit allowance is usually set at £1,073,100 and covers the tax-free lump sums someone receives in their life as well as the ones their loved ones receive on their death.

If you have some form of lifetime allowance protection, then these allowances will be set at a higher level.

When moving to the new regime, your allowances will be reduced based on how much lifetime allowance you have used up.

If you have some lifetime allowance left, then it’s likely you can take more of your tax-free lump sum until you have used up your new lump sum allowance.

For example, if your lifetime allowance was protected at £1.5million, and you have 10% of your lifetime allowance left, then your lump sum allowance would be 10% of £375,000 (a quarter of £1.5million), which is £37,500.

However, this is a complicated area and it is worth checking exactly what new allowances you have left.

If you are paying a pension contribution then even if you don’t receive a tax-free lump sum from the fund built up from it, it may be worthwhile if you receive pension tax relief of 20% plus reducing your higher tax bill.

Finally, EIS (enterprise investment schemes) and VCTs (venture capital trusts) both offer significant tax reliefs on income and capital gains.

However, both are complex, and it may be worthwhile speaking to a regulated financial adviser about these arrangements.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to askrachel@ajbell.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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