However, some people have taken voluntary redundancy (or will be taking it) as a way of easing into retirement. Often they might have long service, so a large amount of the redundancy payment could be taxable.
If your client's over 55 or in their 50s, paying a pension contribution is very attractive as access is close and it's very tax efficient. But action needs to be taken now, before the end of the tax year.
What are the rules on redundancy payments and pension contributions?
The first £30,000 of a redundancy payment is tax-exempt. A redundancy payment can be made up of the actual redundancy payment and other payments such as salary, holiday pay or payment in lieu of notice. Anything over £30,000 and the other payments mentioned, are classed as employment income and count as relevant UK earnings for tax relief purposes.
But those increased relevant earnings will only apply for that tax year.
What about the annual allowance?
When we think about paying large sums into pensions, we always have to consider the annual allowance (AA). In the normal way, if the maximum contribution's paid and that’s over the annual allowance, carry forward of unused AA from previous years will be required to avoid an AA charge.
From 6 April 2016 to 5 April 2020, if clients received larger redundancy payments, there was more risk of the tapered annual allowance applying. However, adjusted income and threshold income increased to £240,000 and £200,000 respectively on 6 April 2020, which lessens the risk. More detail can be found in our article Tapering of annual allowance for high incomes - adjusted and threshold incomes.
Paying a pension contribution
Paying a pension contribution's hugely tax efficient. If your client's a 40% tax payer, they're effectively only paying £60 for every £100. If they're over 55, they can immediately access 25% as tax-free cash.
Most higher rate tax payers are basic rate taxpayers in retirement. So for every £100 they withdraw from their pension, they'll receive £85. This isn’t bad when the contribution cost £60. If the final contribution's made by the employer on the employee’s behalf, there's the benefit of the National Insurance (NI) saving too.
How can a redundancy payment make you a 60% taxpayer?
If someone's a higher rate taxpayer, a large redundancy payment could push their taxable earnings over £100,000. This means they'd start to lose personal allowance on a 2:1 basis, until they lose it completely. This is known as the personal allowance tax trap.
Let’s look at an example.
- Franco's 55. He lives in England and is taking voluntary redundancy in March 2021.
- He'll have a total salary in the 2020/21 tax year of £60,000.
- He'll receive a redundancy payment of £95,000. The first £30,000 is tax free, but the remaining £65,000 will be added to his taxable income.
Franco's lost all of his personal allowance and is paying 60% tax on £25,000. He'll have an income tax bill of £42,500, leaving £76,140 in the bank. So he decides to pay a pension contribution to his Personal Pension (PP) of £20,000 (£25,000 gross). He has the relevant earnings and the AA to support this.
The contribution's deducted from his taxable income, giving him an adjusted net income of £100,000. In turn, this reduces his tax bill by £10,000 and restores his full personal allowance.
The pension contribution of £25,000 extends the amount of income subject to basic rate tax by this amount. Therefore, £12,500 is tax free, £62,500 (£37,500 plus £25,000) is subject to basic rate tax and the remaining £50,000 is subject to higher rate tax.
His bank account's reduced by £10,000 to £66,140, but he has £25,000 in a PP, so he can also claim back higher rate relief. 60% tax relief achieved. And from that £25,000, he can immediately access £6,250 tax free. He can then structure his withdrawals to make sure he's a basic rate taxpayer.
And it gets better…
If Franco’s employer offers salary exchange, the employer pension contribution's £28,450 (employer NI saving of £3,450, plus salary exchange of £25,000). This reduces the total tax by £15,000 to £27,500.
His bank account reduces by £9,500. That's effectively tax relief of nearly 67%. Giving up £9,500 in the bank, but ending up with £28,450 in the pension which can still be accessed immediately – that’s not a bad deal!
If you have clients who are or have been made redundant and are close to or over age 55, and who might not have any relevant earnings in the 2021/22 tax year, it's worth checking whether they can make a large pension contribution before it's too late.
