Paying income tax, at best, is begrudgingly accepted as a necessity. Paying as little as possible is appealing to most of us.

Business owners, and the employed in particular, may well have the ability to reduce their immediate income tax bill and manage it in retirement. In some instances an effective rate of income tax can be shifted from 60% to just over 10% in a relatively short period of time.

Take a director, or senior employee, of a limited company with a salary of £120,000 in their early fifties. At this level of salary the tax free personal allowance of £10,000 is fully lost (£1 of allowance for each £2 over £100,000). The marginal rate of income tax is 40%; and the effective rate is 60% due to the lost personal allowance.

By electing to exchange salary for a pension contribution, the personal allowance can be reclaimed. The employee (including director) should be able to influence the sharing of the National Insurance saving of 13.8%. If this individual exchanges £20,000 of gross salary for pension and redirects the NI this becomes a saving of £22,760.

By making a pension contribution:

He saves income tax at 40% 40%
He regains the personal allowance 20%
He saves personal national insurance 2%
He saves employer’s national insurance 13.8%
Total approximate effective ‘tax’ relief: >75%

How this translates to tax savings

  • Our case study client reaches 55; he retains his personal allowance, with no tax to pay on the first £10,000 p.a. of income
  • He draws £31,865 p.a. of taxable income from his pension savings paying 20% income tax, £6,373
  • He tops up his income with pension tax free cash of, say, £13,955 (the 25% lump sum, that generates the income above)
  • His total “income” is now £55,820
  • His tax bill is £6,373 ÷ £55,820, an effective rate of tax of 11%

This exercise can continue:

  • Until the pension tax free cash is exhausted
  • The State Pension or other pension income is drawn (when voluntary withdrawals would need to be reduced accordingly)

Alternatives to supplement his income in retirement and manage his tax bill

  • Make use of his CGT annual exemption of £11,000
  • Make use of 5% tax deferred withdrawals from investment bonds
  • Make use of his ISA investments through income payments or capital withdrawals

Summary and conclusions

In a world where personal ownership, choice and greater flexibility are the order of the day, pensions appear to be top of the agenda. This example is extreme, but we do see employees in this situation; like all financial advice we encourage to seek advice before taking, or refraining from any action in respect of this blog post.

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