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7 Ways to Use Pensions to Pay Less Tax

Updated: Feb 8

Everyone wants to pay less tax. That’s natural. We all want to preserve the wealth we’ve gone through the daily grind to build up. But it’s surprising how few people are taking advantage of all the opportunities to reduce their tax bill. There are many ways to reduce the income, capital gains and inheritance tax that people pay, specifically when it comes to saving in a pension.

Here are seven ideas for you to consider.

1. Pay more into your pension to reduce your taxable income

This is the easiest way to pay less tax. Contributions made into your pension receive income tax relief at your marginal rate. Employees paying 40 percent tax will see every 60 pence they contribute into a pension immediately boosted to £1 by the government. That’s a very quick return on your investment. Tax relief on contributions is available on contributions up to the lower of the annual allowance of £40,000 or 100% of your income. If you earn £56,000 you can contribute £56,000 and it will only cost you £33,600 if you are a higher rate tax payer. High earners with adjusted incomes of more than £150,000 have a lower maximum annual allowance.

Your employer may be able to add to your contribution as well, increasing the total amount you are setting aside for when you are 55 or older.

2. Make a salary sacrifice agreement with your employer

Doing so may allow you to pay more into your pension without reducing your take home salary at all. This works by reducing your salary to avoid income tax and national insurance contributions. Salary sacrifice is especially helpful if you earn:

  • £50-£60,000 and want to retain any child benefit payments

  • £100-£121,200 and want to retain your personal allowance

3. Withdraw 25 percent of your pension pot as a tax-free lump sum

Once you reach age 55 you can withdraw an initial tax-free lump sum of up to 25 percent of your fund’s value. Invest anything you don’t need in ISAs so that you can avoid paying income tax on future withdrawals.

4. Recycle your tax-free lump sum into a new pension

If you’ve already used up your annual ISA allowances, you might want to consider ploughing some of the tax-free lump sum you’ve withdrawn back into a new pension so that you can receive income tax relief on your contributions. There are very strict rules on recycling and you need to tread carefully if you choose to pay money back into your pension once you’ve taken benefit.

5. Maximise your use of personal allowances

Ensure that you’re taking advantage of any un-used personal allowances available to you by transferring any income-producing assets (such as a buy to let property) to your spouse. The income from that asset will then be associated with their tax account. Rather than paying income tax at your marginal rate of, say 40 percent, on any yield, your spouse could get the first £10,600 tax-free. You could save up to £6,360 a year if you earn more than £100,000.

6. Start up pensions for each of your children (or grandchildren)

Pay £2,880 into each of them every year. Even if they are not earning anything, the government will still apply income tax relief and increase the value of your contribution by 20% up to the maximum of £3,600. Whilst doing so doesn’t reduce your own income tax bill, these are potentially exempt transfers and will not be subject to inheritance tax providing you make the gift at least 7 years before your own death. They offer a “double-bubble” of tax savings!

7. Use your pension to shield your estate from inheritance tax

Keep any assets over and above the £650,000 inheritance tax threshold for you and your spouse in your pension fund. Pensions aren’t counted as part of someone’s estate for inheritance tax purposes. Doing this will avoid IHT at 40 percent were the same funds to be held in elsewhere in your estate. Any unused funds can be passed to beneficiaries who will not need to pay any tax whatsoever on income taken from fund if you are less than 75 years old at death, and the total value of your fund does not exceed £1.25 million. If you die later they will pay income tax at their marginal rate on any withdrawals.

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This article is for information only and should not be construed as advice or a recommendation. The investment strategies mentioned are examples only and may not be suitable for your particular: circumstances, tax position or objectives. Please seek independent financial advice before taking any action.

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