Martin Lewis has outlined important factors to consider regarding pension contributions and their potential impact on your tax allowances. He spoke about a tax 'cliff edge' that is worth knowing about when looking at your pensions.
Advice on a BBC podcast
He issued the advice following a query on his BBC podcast from an employee worried that extra income beyond their regular salary could push them into the higher income tax bracket, and how best to manage this situation. In England, Wales and Northern Ireland, income tax is charged at 20 per cent on earnings between £12,570 and £50,270 annually. When your income exceeds £50,270, the higher income tax rate of 40 per cent applies.
Increasing pension contributions
Responding to the enquiry, Mr Lewis highlighted that if you are approaching the higher rate threshold, there are certain practical things that may be worth doing as they could be "advantageous to you". One option potentially worth exploring is changing your pension arrangements. Mr Lewis said: "You could increase your pension by that amount, because you get that 40 per cent tax relief. As you're paying higher tax, because pension (contributions) come from pre-tax income, you get 40 per cent tax relief on it. Instead of it costing you 80p per £1 you get in your pension, it costs you 60 per £1."
'Cliff edge' tax rule
Mr Lewis highlighted a significant tax change that occurs when you enter the higher rate bracket, which is worth thinking about when planning your pension contributions. He said: "The reason you may not want to be a higher rate taxpayer, apart from paying more tax, is crucially because, if you become a higher rate taxpayer, your personal savings allowance drops. There is a cliff edge here." This is because the moment you enter the higher income tax band, the amount of tax-free interest you can accumulate annually outside of ISAs falls from £1,000 to £500. Higher rate taxpayers presently face tax on their interest income at their marginal rate of 40 per cent, meaning you could potentially face an extra £200 tax bill by losing £500 of the allowance.
Impact on savers
Mr Lewis warned: "You actually lose quite a nice chunk of your ability to earn interest tax-free. If you are not earning (taxable) interest on savings, it doesn't really make much difference to you at the moment anyway, but it might do in future." But certainly if you're only dripping a tiny bit into the higher rate tax threshold, then you could utilise increasing your pension contributions to reduce your salary, so that you are no longer a higher rate taxpayer. That would mean you would keep the £1,000 a year of interest that you can get tax-free from savings.
Tax changes
Several major savings tax changes are coming in soon. From April 2027, the existing £20,000 ISA allowance will be reduced. Savers can presently allocate this allowance as they wish between cash ISAs or stocks and shares ISAs. However, from next year, savers will only be permitted to use up to £12,000 at their discretion. The remaining £8,000 will only be available for deposits into investment-based accounts. The tax rate applied to interest earnings is also rising, climbing by two percentage points across each tax band. This means basic rate taxpayers will see their rate climb from 20 per cent to 22 per cent. Higher-rate taxpayers will see their rate rise from 40 per cent to 42 per cent. Additional rate payers will see an increase from the present 45 per cent to 47 per cent.
