How to mitigate frozen allowances by pension saving

This will be brought even more into relief as 'tax day' approaches and the chancellor puts forward his proposals to change certain tax structures.

But one thing that did change in the Budget was the news that the personal allowance – the amount of income one can earn in a tax year that will be free from income tax – will be frozen at April 2021 levels until 2026. 

FTAdviser In Focus caught up with Steven Cameron, pensions director at Aegon, to talk about why it makes a big difference to put as much aside into a pension pot as possible, especially for those higher-rate taxpayers caught out by the personal allowance freeze.

FTAdviser: Why is this being called a 'stealth tax' and how might it affect people in the future? 

Steven Cameron: While the chancellor didn’t increase income tax rates in his Budget, he did freeze the thresholds when people start paying basic and higher rates of income at the levels for 2021/22. 

The Office for Budget Responsibility forecast shows this could mean 1.3m extra people start paying income tax and 1m will become higher-rate taxpayers.

The simple message is that if you are over the higher-rate threshold, you get more tax relief on pension contributionsSteven Cameron

This is based on relatively conservative assumptions around future earnings growth of between 1 per cent and 2 per cent a year.

FTA: So any pay rises we might hope for amid this climate could end up tipping people over the edge into a higher-rate tax band? 

SC: Many people may have been relieved to find that the chancellor in his Budget didn’t push up rates of income tax, as per one of the government’s manifesto commitments from 2019.

But according to the OBR it could mean over the next five years, 1m will find that because of even modest increases in their earnings, they will start paying higher rate income tax.

In England this will mean those whose earnings cross the threshold of £50,270 will pay 40 per cent on earnings above this, twice the basic rate of 20 per cent.

For them, an increase in the basic rate from 20 per cent to, say 22 per cent, might no longer look so bad.

The OBR makes assumptions above average increases in earnings in future years of between 1-2 per cent. If you’re earning over £46,442 and you received 2 per cent pay increases for the next four years, your earnings would be above £50,270 and you’d become a higher-rate taxpayer.

FTA: Why is paying more into a pension a good way to mitigate the effects of this?

SC: If you’re one of those estimated 1m people where a much-needed pay rise means you face paying higher rate tax, one way to avoid this is to pay more into your pension. Your pension contributions get ‘tax relief’ at your ‘highest marginal rate’. 

The way this works varies, but effectively, if you’re a higher-rate taxpayer, it costs you £600 ‘net’ for every £1000 going into your pension. That’s a much better deal than basic-rate taxpayers for whom it costs £800 net for every £1000.

FTA: Pensions and tax – two things that sound tricky for many people to understand easily. How can we simplify them in layman's terms?

SC: The simple message is that if you are over the higher-rate threshold, you get more tax relief on pension contributions.

So, if you are already a higher-rate taxpayer, or if you find that the freeze on thresholds means you become one in future years, it might be worth considering paying more into your pension and getting higher-rate tax relief while you still can.

There can be additional benefits in doing so for those in receipt of child benefit.

FTA: Should people getting a pay rise be using AVCs if their scheme allows it?

SC: I’m not sure I would use the term AVCs rather than just ‘additional contributions’. AVC is a term which is used under trust-based schemes – paying voluntary contributions on top of the scheme’s regular contributions which are a condition of scheme membership.

Some trust-based defined contribution schemes may operate separate AVC sections under the scheme. With others, it might go into the same pot (like group personal pension schemes).

It’s unusual for an employer or a provider of a personal pension to limit pension contributions other than the annual allowance [currently £40,000 this tax year]. If your employer will match additional contributions, then the benefits of increasing are doubled again.

FTA: Are there downsides to AVC or 'additional contributions'? They seem quite easy to work out in terms of calculating the cost as a percentage of salary per month.

SC: Some schemes or employers might be less flexible than others – eg only allowing you to change your contributions once a year, such as during the flexible benefits window.

This is normally related to employers trying to manage payroll issues. So a downside would be if the scheme is inflexible and doesn’t allow you to change your contributions quickly.

Another downside would be if changes have to be made using paper instead of online. Employers will have payroll cut-off dates for making changes. Some may take longer than others to make the changes. It depends on the payroll provider capability.

FTA: Do you think there might be more tax devil-in-the-detail come March 23 (the so-called tax day)?

SC: Tax day is supposed to be about tax administration, launching detailed consultations on that. But there’s also the potential for other less ‘admin’ consultations to be launched, for example on capital gains tax reform.

One I expect to see more of is third parties being asked to provide data on pension contributions and possibly other financial transactions to HM Revenue & Customs to pre-populate tax returns.

While some aspects might be worthwhile, others might create huge complexity.

simoney.kyriakou@ft.com