Pensions: 40% tax relief not enough – Does 400% sound more tempting?

It is common knowledge that higher rate taxpayers can receive tax relief at 40% on pension contributions. Less commonly known is that it’s possible to receive effective tax relief of well over 100%, and sometimes as high as 400%. Sound too good to be true? In the right circumstances this can be achieved with straightforward and uncontroversial planning.

Let’s look at an example. Mr Darling was born on 1 January 1948 and earns a salary of £35,000 in 2007/08 with no further income and makes no pension contributions. He invested £100,000 into an onshore insurance bond on 1 January 1988. He has never made any withdrawals or further contributions into the bond. He encashed the bond for £250,000 on 1 January 2008, thus making a chargeable gain of £150,000. He will suffer an income tax liability of £10,700 on the bond gain. This is calculated as follows. The top-sliced bond gain for each year is £7,500 (£150,000/20). The remaining basic rate tax band is £4,825 leaving £2,675 to attract higher rate tax. Total tax due is 20 (years) x £2,675 x 20% = £10,700.

His tax position will be:

Income £35,000
Allowance £5,225
Taxable Income £29,775

£2,230 taxed @ 10% £223
£27,545 taxed @ 22% £6,059
£4,825 top sliced bond gain (tax paid) £0

Plus overall tax on bond £10,700
Total Income tax liability £16,982

What is the position if Mr Darling were to make a net pension premium of £2,086.50 in 2007/08? A net pension premium of £2,086.50 increases his basic rate tax band by the gross premium of £2,675 (£2,086.50/78%). The pension contribution leaves £7,500 of his basic rate band unused which equals the entire top sliced gain of £7,500 (£150,000/20 years) on the bond.

Income £35,000
Less personal allowance £5,225
Less gross pension premium £2,675
Taxable income £27,100

£2,230 taxed @ 10% £223
£24,870 taxed @ 22% £5,471
£7,500 top sliced bond gain (tax paid) £0

Plus overall tax on bond £0
Total Income tax liability £5,694

The total income tax saving is £16,982.90 - £5,694.40 = £11,288.50 or 422% of the gross pension premium of £2,675. So by paying £2,086.50 into a pension, Mr Darling could save tax of £11,288.50.

Conclusion

Life assurance taxation can be exceedingly complex and there are many potential pitfalls for the unwary. Bond holders must receive advice on the best method to implement and exit their investment with the minimum tax charge. There are a number of planning opportunities open to both onshore and offshore bonds not available to investments subject to CGT. These include assignment to spouses or children, an annual programme of encashments or encashment when non-UK resident. Careful planning around encashments and utilising pension contributions can result in incredible tax savings, sometimes outweighing the amount of the pension contribution. The above example provides effective tax relief of 422%, but even assuming a salary of £75,000 within the above example, paying a net pension contribution of £33,286.50 would save tax of £45,720 or effective tax relief of 107%. Remember this planning is uncontested and not aggressive. For a detailed factsheet please click here.

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