Could using a pension reduce higher rate tax payments?

27 April 2021

At the beginning of March Chancellor Rishi Sunak presented his Budget. His aim: to chart a course out of the economic damage wrought by the pandemic. A year earlier he had said he would do “whatever it takes” to protect jobs and businesses. Twelve months on, with Government borrowing breaking all records, it is clear that it will take a very long time to pay the bill for “whatever it takes.” 

One of the key measures in the Budget was the freezing of personal allowances: the higher 40% rate will be frozen at £50,270 from April 2021 to the 2025/26 tax year. This means that 5m people in the UK – roughly one in six taxpayers – will be paying higher rate tax by 2026 as wages rise with inflation. As many commentators pointed out, it looks like middle class savers will be paying the bill for the pandemic. 

Is there any way to avoid this? Good news! – The answer is ‘yes.’ Putting more money into your pension will help you save for the future and avoid an increasing tax bill. This is because pension contributions attract tax relief at the same rate you pay income tax, meaning savers could effectively eliminate higher-rate tax bills by saving anything above £50,270 into their pensions. 

Under the proposed tax freeze, someone now earning £49,000 whose pay rises by 3% per year will see their annual tax bill increase by £3,128 by 2026. However, if they put £500 per month into their pension, their tax bill will be just an extra £609 – despite them earning an extra £7,804 by the end of the Chancellor’s freeze. 

What the freeze on thresholds – which also sees the basic rate threshold frozen at £12,570 – very clearly illustrates is the need for financial planning. This is not the place for complicated examples, but what is clear is that many people will enjoy significant pay rises over the next five years and will – without adequate financial planning advice – end up paying significantly more in tax. 

It is worth pointing out that the freeze on thresholds also applies to inheritance tax, with that threshold frozen at £325,000. Many people will find themselves paying significantly more tax on their earnings and – without proper planning – seeing the value of their parents’ estates reduced by inheritance tax. 

The Daily Telegraph described the tax rises in the Budget as ‘eye-watering,’ commenting that they take the UK back to levels of taxation not seen since the sixties. What’s clear is that the Chancellor’s decision to freeze thresholds to pay part of the bill for the pandemic makes long-term financial planning more important than it has ever been.