If I pay enough into my pension, can I get rid of income tax?

Of all the pensions questions I’ve been asked by contractors of late, ‘If I pay enough into my pension, can I get rid of income tax?’ has got to be up there with the most interesting, writes Angela James of Yolo Wealth.

Nothing is certain except death and taxes

Certainly, a pension is a great way to limit your tax liabilities with HMRC but sadly as they say in life, ‘Nothing is certain except death and taxes.’

So while you can utilise a pension to save some of your hard-earned income from the taxman, it’s unlikely you could completely negate all your income tax with a pension alone.

That said, your ability to negate will depend on your own individual circumstances and how well informed you are. Indeed, with some careful financial planning, and a good adviser you could certainly save in some cases significant pots to HMRC, through the right investments and if you have the means and risk-appetite to do so.

Pension allowances

In principle, pensions enable contractors to pay little to no tax at all on income, and on this basis you should make a personal pension contribution knowing you are able to invest 100% of your UK relevant income.

Income that is considered ‘UK relevant’ earnings are income such as salary, bonuses and overtime, but what is not considered relevant earnings are rental income, dividends or pension income.

For example, if you earned £50,000 salary plus a £5,000 bonus then you could invest £55,000 into a pension in that relevant tax year and receive 100% tax relief for this contribution. A personal contribution is a contribution made by you and not your employer on your behalf.

However, the majority of people do not have the budget to invest 100% of their income into pensions, as we all need money for our costs of living and day to day expenses which is why I say, above, that although a pension could have the means to remove all income tax liabilities for a given year, it is not usually a viable option for most people. Unless you have savings in the bank that you’d like to withdraw!

Let’s now touch on employer contributions that you may make for yourself via your own limited company, or should you be employed, your employer adds contributions as part of your package.

Contractors, tax relief isn’t for your benefit…

These contributions attract tax relief -- but not for your benefit! The tax relief on these is provided to the employer making the contribution based on the amounts they invest.

You should note that each of us individually has an annual pension allowance each tax year, in the current tax year this is a maximum of £60,000 or 100% of your UK relevant earnings whichever is the lower. No additional tax relief is available to you over an above these limits, and any employer contributions you make or receive are included within this total allowance.

As any good pensions adviser will tell you, the so-called ‘Carry Forward’ method is the best option to use some or all of your unused allowances from the previous three tax years. This may offer some individual contractors higher allowances for a particular tax year but be aware -- there are strict rules that apply and individual criteria needs to be explored and understood. Again, getting an adviser across your finances is your best bet.

Higher earners and reduced personal allowance

For contractors who earn over £100,000 a year in income, you may be aware that your ‘personal allowance’ (this is the threshold of earnings that is not subject to tax), is reduced by £1 for every £2 you earn over the £100,000 threshold.

This means if you have total income, from all sources over £125,140 then you would have no tax-free allowance at all.

A pension could be utilised to restore some or all of this personal allowance. In this example, if you had the available allowance to do so and the budget, if you were to invest £25,140 into a pension then this would reduce your adjusted income back to the £100,000 and therefore in turn restore your full personal allowance.

You could also consider a pension contribution to reduce your adjusted income thresholds back for child benefit purposes (if appropriate), for those in and around that threshold of income. Although not a tax relief, it is still an additional benefit consideration.

Other investments (aka EIS and VCT)

There are some alternative investments that offer tax advantages such as Venture Capital Trusts and Enterprise Investment Schemes.

Although these are very complex investments, and not suitable for the majority of contractors trying their hand at investments, I would urge you to get advice on these investments if you are not an experienced EIS or VCT investor, as they can have an appeal for tax planning purposes.

These investments offer significant tax credits when utilised correctly. They are an initiative introduced by the government many decades ago, but still today encourage investment into Britain’s entrepreneurial businesses – which contractors might resonate with.

In particular, VCT & EIS investments could offer a 30% tax credit on investment made, subject to annual limits each tax year. The key difference to a pension is that there are no age restrictions on encashment or restrictions on the income the tax relief is applied too. The tax credit can be used against all income from all sources, which could make them appealing for experienced investors with high dividend income or rental income.

EIS can also have advantages for inheritance tax planning. These investments must be held for a certain number of years to retain your tax relief. An adviser is a sensible consideration here.

So, can a maxed-out pension nullify income tax? Yes and No

As you can hopefully see, there are many ways to plan efficiently so you’re HMRC bills are minimised. In short, make the most of your finances, invest in an adviser and secure your financial future by retaining more of your income in your pocket than that of the taxman!

But for the majority of us, although we could reduce our tax liability, there aren’t many of us who have the means to completely negate tax -- although you could say it is possible.

Very finally, to be forewarned is to be forearmed. If you have not had a review with a financial adviser in the last few years, or never had financial advice, or it’s been a while since you sat and took stock of your financial health, then please take advantage of a consultation with me. Of course, if you have the knowledge or time to do this yourself then there is always value in you making a solid start! If nothing else, it’s usually a valuable life admin exercise! For everyone else though, my initial consultation comes with no obligation and at my own expense, and we can discuss your own position and explore if there are opportunities for you – even if getting rid of income tax entirely might be a bit of a stretch.

The value of pensions and the income they produce can fall as well as rise. You may get back less that you invested

Tax treatment varies according to individual circumstances and is subject to change

Venture Capital Trusts & Enterprise Investment Schemes invest in assets that are high risk and can be difficult to sell. The value of the investment and the income from it can fall as well as rise and investors may not get back what they originally invested, even taking into account the tax benefits.

Approver Quilter Financial Services Limited & Quilter Mortgage Planning Limited. 21/06/2024