Turning a pay rise into a financial win: how pension planning can help individuals keep their childcare benefits
This case study looks at how exceeding £100,000 adjusted net income can trigger the loss of childcare benefits and the personal allowance, resulting in a high effective marginal tax rate. It shows how making pension contributions can restore lost benefits and optimise net family income.
Meet Ashley and Michael
Meet Ashley and Michael, a London-based couple with lively twin two-year-olds keeping them on their toes. Ashley earns £95,000 a year, while Michael earns £60,000.
The twins attend nursery and each benefit from thirty hours of free childcare a week for thirty-eight weeks, thanks to the Government’s Free Childcare for Working Parents scheme1. However, the couple still incurs additional childcare costs of £20,000 a year. To help with this, Ashley has signed up for the Government’s Tax-Free Childcare scheme, which provides a further £4,000 a year (£2,000 per child).
1Free Childcare for Working Parents: Overview - GOV.UK
Ashley’s Dilemma
Ashley’s been offered an exciting new job with a significant pay rise, taking her salary up to £120,000 a year. While this is a fantastic opportunity, she’s aware of the financial implications of earning over £100,000.
Once her adjusted net income exceeds £100,000, she’ll no longer be eligible for the Government’s Free Childcare for Working Parents scheme or the Tax-Free Childcare scheme. Additionally, her personal allowance will reduce by £1 for every two pounds she earns over £100,000, effectively subjecting her to a 60% tax rate on the £20,000 above this threshold. She’ll also need to pay 2% National Insurance on the additional income.
After accounting for these deductions, the extra £25,000 salary will leave her with a net increase of £10,5002. However, losing £23,1293 in Government childcare support means she’ll actually be £12,629 worse off than she is currently.
2Income tax on first £5,000 = £5,000 x 40% = £2,000
Income tax on next £20,000 = £20,000 x 60% = £12,000
National Insurance on £25,000 = £25,000 x 2% = £500
3Average nursery cost per hour in London is £8.39 Childcare Costs in RM3 - Childcare.co.uk
30 hours per week for 38 weeks = £8.39 x 30 x 38 = £9,564.60 x 2 = £19,129.20.
Plus £4,000 from the Government’s Tax-Free Childcare scheme.
How pension contributions can help
Ashley’s financial adviser explains that by making pension contributions, she can reduce her adjusted net income, recover both Government schemes, and avoid the personal allowance tax implications. Adjusted net income, which is your total income after certain deductions, is a key factor in determining eligibility for Government schemes.
To bring her adjusted net income below £100,000, Ashley would need to make a gross pension contribution of £20,001, reducing her adjusted net income to £99,999. This would allow her to remain eligible for both Government schemes and avoid the personal allowance reduction.
Unfortunately, Ashley can’t afford to pay £20,000 but she can pay £800 per month which will get grossed up to £1,000 per month due to basic rate tax relief. As her parents have a potential IHT problem, they agree to pay an annual amount of £8,000 per annum to her pension via normal expenditure from income. This will reduce the IHT bill by £3,200 per annum. The parent’s contribution will also attract basic rate relief and will be grossed up to £10,000.
Together, Ashley’s and her parents’ contributions will total £22,000 a year, reducing her adjusted net income to £98,000. As a higher-rate taxpayer, Ashley will also be able to claim back 20% tax relief on the total pension contribution, amounting to £4,400.
The final outcome
By taking these steps, Ashley’s adjusted net income will still be £3,000 higher than in her current role, netting her an additional £1,740. On top of this, she’ll receive £4,400 in extra tax relief, recover the £23,129 she would have lost from the Government schemes, and have £22,000 added to her pension, helping to secure her financial future.
On an individual basis, instead of being £12,629 worse off as a result of the pay rise to £120,000, by paying in a net pension contribution of £17,600, Ashley will effectively receive £6,140 more than on her current salary. She will be able to receive £23,129 from the Government schemes, and have £22,000 in her pension. That’s a total gain of £46,2984.
On a family basis, including the £3,200 reduction in her parents’ IHT bill means that the total tax relief and financial gains for the family amount to £49,498—an impressive 281.2% return on the net pension contribution.
By making these changes, Ashley can not only help secure her family’s financial future but also enjoy peace of mind knowing she’s making the most of her income.
Disclaimer
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.