How pension contributions can save tax and reduce childcare bills

Being a parent can pull your time and finances in different directions. It is difficult to save for the future whilst paying for childcare, such as nursery. One highly effective strategy to manage short and long-term financial planning is using pension contributions to keep your income below the £100,000 threshold.

This tactic can help you preserve your personal allowance which could provide you with effective tax relief of over 60%. It can also preserve your tax-free childcare entitlement, a benefit that can save you up to £2,000 per child per year in childcare costs.

The £100,000 threshold: a key tax consideration

In the UK, your personal allowance, or the amount of income you can earn tax-free, starts to phase out once your income exceeds £100,000. For every £2 above this threshold, you lose £1 of your personal allowance. By the time your income hits £125,140, your personal allowance is reduced to zero, meaning you pay income tax on more of your earnings than you would have if you had stayed under the £100,000 mark. This ‘stealth tax’ is often described as the 60% tax band because your 40% tax rate is effectively increased to 60% by the loss of your personal allowance.

However, there is more at stake when your income exceeds £100,000 for families that are eligible for tax-free childcare.

Tax-free childcare: what is it and how does it work?

Tax-free childcare is a government scheme designed to help working families with the cost of childcare. The government will pay 20% of your childcare costs, up to a maximum of £2,000 per child per year (or £4,000 if the child has a disability). However, to qualify for tax-free childcare, your individual income must be below £100,000, or you lose it completely.

Pension contributions can act as a powerful strategy to keep your income below £100,000, ensuring you continue to receive this valuable benefit.

How pension contributions can help

Pension contributions are one of the most effective ways to reduce your taxable income. Personal contributions to a pension scheme attract tax relief at basic rate (20%) immediately. This means that if you contribute £8,000 then the government will automatically increase this to £10,000 so that the higher amount is what is invested into your pension. If you are a higher or additional rate taxpayer, you can claim the extra tax back on your tax return. If your pension contribution brings your income to below £100,000 then you can also reclaim your personal allowance, providing that extra tax break.

Contributing to your pension also lowers your income, enabling you to stay below the £100,000 threshold for the purposes of tax-free childcare.

Another effective way to do this without the need for a tax return is to ask your employer to make the pension contributions via salary sacrifice whereby you give up the equivalent amount of salary to make the gross pension contribution. This means tax is not paid on this element of your earnings so no tax reclaim is needed. Care should be taken with salary sacrifice arrangements as it may affect affordability for things like loans and mortgages.

The double benefit: tax relief and reduced childcare costs

The real power of using pension contributions to keep your income below £100,000 is that it provides a dual benefit:

1. Tax Relief: As we have already discussed, pension contributions provide tax relief and reduce your taxable income, which helps you retain your personal allowance and avoid the additional tax that comes with losing it. This alone can save you a significant amount of money.
2. Tax-Free Childcare: By ensuring that your income remains below the £100,000 mark, you preserve your eligibility for tax-free childcare. With childcare costs continuing to rise, this government scheme can provide crucial financial support for families, covering 20% of your costs up to the annual maximum.

Considerations

While the strategy of using pension contributions to manage your income is highly effective, it is important to keep a few things in mind:

1. Contribution Limits: Be aware of your pension contribution limits. The £60,000 annual allowance is the maximum amount you can contribute to your pension while receiving tax relief. If you exceed this, you could face a tax charge.
2. Other Deductions: Ensure that you account for any salary sacrifice arrangements or other deductions that might impact your overall taxable income.
3. Long-Term Planning: While reducing your taxable income through pension contributions can provide short-term tax savings, make sure you are contributing enough to meet your retirement goals. Pension contributions are a long-term commitment, so balancing short-term tax planning with long-term savings is key.
4. Access: You cannot access money within your pension until minimum pension age, which is currently age 55, moving to 57. This means that you need to consider your need for access before this age when making a pension contribution.

Conclusion

Using pension contributions to keep your income below £100,000 is an effective strategy that not only helps you reduce your tax bill but also ensures you can take advantage of important benefits like tax free growth within pensions and tax-free childcare. By collaborating with a financial planner at Carbon, you can tailor this strategy to your individual needs and create a comprehensive plan that enhances your financial well-being going forward.

If you are interested in learning more about how pension contributions can help you, don’t hesitate to get in touch with us at enquiries@carbonfinancial.co.uk

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action. Tax and Estate Planning Services are not regulated by the Financial Conduct Authority. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.