How paying into your UK pension can help you avoid a tax ‘trap’

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UK tax law is among the most complicated in the world. Trying to understand all the allowances, exemptions and tax rates can be a challenge for even the most qualified professionals, and there are ways it can catch you out.

If you’re living and working in the UK, there is a common tax ‘trap’ that you could easily fall into. Here’s what to look out for, and how you can deal with the issue.

The Personal Allowance trap means you could pay 60% Income Tax

Every individual in the UK benefits from a Personal Allowance. This is the income you can earn before you start to pay Income Tax and, in the 2020/21 tax year, stands at £12,500.

So far, so straightforward.

However, if you earn more than £100,000 each year, you’ll find that your Personal Allowance is reduced by £1 for every £2 over the £100,000 limit. If you earn more than £125,000 a year, you’ll lose your Personal Allowance entirely.

What this means is that the £25,000 you earn over £100,000 is effectively taxed at a 60% rate.

So, how can you avoid this?

One of the common ways to sidestep this tax trap is to reduce your earnings below the £100,000 threshold, whereby you would retain your entire Personal Allowance. For example, you could pay £25,000 into your pension. A pension contribution of £25,000 (including the basic tax relief) only results in a reduction to income after tax of £10,000 (see the table below).

You could also consider ‘salary sacrifice’. In return for giving up part of your salary, you can receive a benefit of equivalent value, retaining your overall remuneration but deflating your taxable income.

Using ‘salary sacrifice’ – i.e. give up part of your income for another benefit could be even more appealing. By using salary sacrifice, the employer pension contribution is £28,450.00 (employer National Insurance saving of £3,450 plus salary exchange of £25,000) and your income only falls by £9,500.

The table below shows how making a pension contribution can benefit you, including using ‘salary sacrifice’.

Source: Royal London

Taking this approach means you could make pension contributions in the UK to avoid paying additional tax (at, potentially, 60%), transfer the pot to a superannuation in Australia at age 55, and potentially take it tax-free at 60 or 65 depending on whether you are still working.

Get in touch

This is a complex area, but the upside can be considerable. We’ve helped countless clients avoid tax traps in these ways, particularly when it comes to your pension contributions.

As a cross-border financial planning firm with offices in both the UK and Australia, we’re uniquely placed to help you with your financial arrangements – and this includes the tax implications of income and pensions.

Get in touch to find out how we can help.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.