Six pension tips to slash your tax bill

Pensions can be a great way to reduce your tax bill, as well as helping you save for a comfortable retirement.

A pension is a fantastic way to save for your retirement but it can also be a handy vehicle to make some big savings on your tax bill.

How much you can save will depend on your circumstances, but some careful planning will help you keep more of your money out of the taxman’s coffers. This is our round-up of six of the best ways your pension can save you tax.

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1) Save big with tax relief

The first big tax saving you can make is on the contributions you pay into your pension. As an incentive to save more towards retirement, the government gives you tax relief on your contributions.

For a basic-rate taxpayer, tax relief of 20% is paid, effectively giving you back the income tax you paid on your contribution. This means that for every £100 you pay into your pension, you will receive £25 in tax relief, giving you a total contribution of £125.

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Higher and additional rate taxpayers can currently claim back a further 20% and 25% respectively through their self-assessment tax returns.

Whatever your tax band, there are limits on the amount of relief you can receive. You can pay in up to 100% of your income in any tax year, subject to a maximum of £40,000. Plus it’s only available up to age 75.

You can even get tax relief if you do not have any earnings, for instance if you are unemployed, bringing up your family or you want to start a pension for a child. If your annual earnings are £3,600 or less, you can contribute up to £2,880 a year and it will be topped up with tax relief, to a maximum contribution of £3,600.

2) Take back your child benefit

Your pension could also benefit your children. If you have kids and you or your partner earn more than £50,000, you stand to lose some, or all, of your child benefit through a higher rate child benefit charge.

The tax charge is levied on the higher earner at the rate of 1% of your child benefit for every £100 of income above £50,000. So, earn £55,000 and you will lose 50% of your child benefit; earn £60,000 and you will lose the lot.

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You may be able to get it back by using your pension. As the taxman uses your income after pension contributions, if you can afford to pay in enough to get below £50,000, you will hang on to your child benefit.

For example, if you have one child and you earn £56,000, you will lose 60% of your child benefit, giving you £8.72 a week. Pay £6,000 (£4,800 + £1,200 in tax relief) into your pension and you will get the full £21.80 in child benefit.

3) Dodge the £100K tax trap

Fortunate enough to earn a six-figure salary? Nice one, but earning more than £100,000 comes with a nasty sting in the tail. For every £2 of earnings over £100,000, your personal income tax allowance is reduced by £1, with it completely swallowed up if you earn £125,140 or more. This clawback also means you effectively pay 60% tax on any earnings between £100,000 and £125,140.

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Your pension can help you reduce – or completely avoid – this tax trap. Say you earn £120,000. This would wipe £10,000 off your personal tax allowance. But, as the taxman assesses your income after pension contributions, you could take back your full personal tax allowance by making a £20,000 contribution (£16,000 + £4,000 in tax relief) into your pension. Plus, as a higher-rate taxpayer, you would be able to claim back a further 20%, another £4,000, in your tax return.  

4) Crush a capital gain

If you are going to sell an investment that will leave you with a capital gains tax (CGT) bill, your pension could help you reduce the amount. Capital gains are taxed at 10% for basic-rate taxpayers and 20% for higher-rate taxpayers (18% and 28% respectively for gains from residential property), with the rate determined by adding the gain, minus the annual CGT allowance (£12,300), to your income.

For example, say you sold some shares for £30,000, which you originally bought for £10,000, giving you a gain of £20,000. This gain is reduced to £7,700 as the CGT allowance can be deducted. This £7,700 gain is then added to your £45,000 income.

The first £5,270 falls within the basic rate band – generating a CGT liability of £527 – with the remaining £2,430 subject to the higher rate of CGT at 20%, equivalent to a further £486. This gives a total CGT bill of £1,013.

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Making a pension contribution could bring all the gain into the basic-rate band. In this example, a pension contribution of £2,430 (£1,944 + £486 in tax relief) would bring all your gain into the basic-rate band. This would give you a CGT bill of £770 – saving you £243 in CGT – and put £2,430 into your pension.

5) Go tax-free in retirement

When you get to take your pension, up to 25% of it can be taken tax-free. This could be as a lump sum or more gradually when you need it.

Everyone loves the idea of money being tax-free so it can be tempting to grab the lot as soon as possible. But before you do this, make sure it is the best option for you.

First, think about why you want the money. If you want it to pay off your mortgage or other debts, or you are keen to help the kids on to the property ladder, then it may be worth taking what you need. If you have no immediate plans for it and it is just going to languish in your savings account, it may be better left in your pension. There, it can enjoy tax-free investment growth, that could potentially mean more tax-free cash in the future. 

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Withdrawing it gradually also opens up some handy financial planning opportunities. For example, you could stagger pension withdrawals to use up your income tax allowance each year. Assuming you have no other taxable income sources, you could take £16,760 a year - £12,570 taxed and £4,190 tax-free – without an income tax charge.

6) Keep inheritances tax-free

Your pension is also a really effective inheritance tax (IHT) planning vehicle. Anything that is in your pension fund when you die, can be left to your beneficiaries free of inheritance tax.

They may have to pay income tax on this inherited pension, depending on your age at death. Under 75, and they can take it as a lump sum or an income, completely tax-free. Older, and whatever they take will count towards their income and be taxed accordingly.

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Even if they do end up paying income tax, it can still end up more tax-efficient than having to pay inheritance tax on it. Inheritance tax is charged at 40% on anything over the £325,000 threshold so, unless your beneficiary is a higher-rate taxpayer hellbent on emptying your pension pot in one go, the tax bill should be lower. A bit of careful planning and attention to tax allowances and they could stagger withdrawals to keep the income tax liability as low as possible.  

If you can afford to leave your pension untouched, it is also a much simpler way to reduce an inheritance tax liability than remembering to use up annual allowances and exemptions or setting up trusts. Just remember to check who you nominate as your beneficiary – you may want to choose a different person or persons to those you selected when you started saving into your pension.