Can I reduce my income and tax bill by paying into a pension?

6 min Read Published: 23 Jan 2020

This article was inspired by a question posed and answered in the Money to the Masses facebook community group. Join the thousands of group members and get your money questions answered.

Reader question:

Can my wife retrospectively pay pension contributions for last tax year (i.e. 2018/19) to reduce her income for the current tax year? The problem we are trying to solve is my wife's self-assessment tax return ahead of the 31st January deadline. We are trying to bring down her taxable income so we don't reach the higher rate income tax threshold. She earned £17,000 employed income this year but has not contributed to any pension in the 2019/20 tax year, though she's a member of two existing pension schemes. Due to her income from a buy to let property she will be in the higher tax rate band and potentially lose her child benefit. In addition, she sold a property last year hence the Capital Gains Tax (CGT) will be charged at 28% instead of 18% if she was able to keep within the basic rate band.

Answer:

The simple answer is no you can't reduce her income in the way you suggest. With regard to pension contributions and past tax years, you are allowed to carry forward any unused annual allowances from the previous three tax years but there are strict rules.

The annual allowance is the maximum amount you can contribute to a pension each year and still receive tax relief. The amount is the greater of £3,600 or 100% of your relevant earnings, capped at £40,000. These are gross numbers. Importantly, 'relevant earning's' does not include income from investments or rental income.

The annual £40,000 cap is reduced to £4,000 on defined contribution pensions (and not defined benefit pension schemes) if you cash in a pension or start to draw an income from a pension via flexi-access drawdown. This reduced allowance is known as the Money Purchase Annual Allowance (MPAA). Alternatively, the normal £40,000 allowance can also be reduced or 'tapered' (down to £10,000) if your 'threshold income' is over £110,000. Threshold income is your annual income before tax less any personal pension contributions and ignoring any employer contributions.

To explain how the carry forward rules work (and why they won't help you achieve what you are trying to do), assume a person has a total earned income of £60,000 and that they have the full annual pension contribution cap of £40,000. They would first have to contribute the maximum allowance of £40,000 for the current tax year (2019/20) before they could use the carry forward rules. They could then contribute the remaining £20,000 'into' previous years using the carry forward rules. However, they must go back 3 tax years first (to 2016/17) and use up any unused allowance from the £40,000 allowed at that time (assuming that the full annual allowance was available). So if they had previously contributed £10,000 in the 2016/17 year the aforementioned spare £20,000 would be allocated for that year. This means that they would not affect the 2018/19 year at all. The only way it would be possible is if the person was able to contribute a sum equivalent to ALL of their earned income for 2019/20 and have already maximised pension contributions in 2016/17 and 2017/18 tax years.

Furthermore, the person would have to have been a member, even if not contributing, to a pension scheme for each of the years in question in order to take advantage of the pension carry forward rules.

With regard to losing your child benefit, here is the official child benefit clawback calculator which will work out how big any potential clawback will be. While it may be tempting to stop claiming child benefit (or at least opt-out of receiving it) bear in mind that your wife's income for next year (2020/21) might be under the threshold (also there could be new tax allowances, pension contributions rules etc. announced in the upcoming Budget) meaning that it might no longer be a problem. Even if you do end up "losing" your child benefit, by claiming it and then repaying it through the high-income child benefit tax charge you ensure full state pension benefits for your wife assuming that she is the named claimant.

Another point to consider is that high-income child benefit tax charge (HICBC) comes into effect for those where either partner has an adjusted net income over £50,000 and they are receiving child benefit. So you also need to be mindful about your own income. To avoid the HICBC you would need to reduce your wife's adjusted net income and that can include by making pension contributions.

Paying into a pension is just one way of the ways you can reduce the amount of tax you pay. For more ideas on how to pay less tax, check out our article '39 simple ways to pay less tax'.

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