The tax year end is approaching, and changes to Income Tax rate bands will come into effect. The Personal Allowance, for instance, will rise from the current £12,500 by 0.5 percent to £12,570.
However, various tax thresholds will subsequently be frozen for five years, Chancellor Rishi Sunak announced earlier this month.
The measure has been taken to increase Government revenue via fiscal drag, following the unprecedented levels of public spending in response to the coronavirus pandemic.
Having announced the decision to freeze personal tax thresholds, in his Budget speech, Mr Sunak said: “We will of course deliver our promise to increase it again next year to £12,570, but we will then keep it at this more generous level until April 2026.
“The Higher Rate threshold will similarly be increased next year, to £50,270, and will then also remain at that level for the same period.”
While the rate isn’t changing, over time, this will mean taxpayers end up paying more Income Tax.
However, according to Steven Cameron, Pensions Director at Aegon, the decision means pension planning is “about to get doubly attractive for a million more UK taxpayers”.
For the new one million new higher rate taxpayers, a £1,000 pension contribution will only cost £600, rather than £800 – which it would have been if they remained basic rate taxpayers.
However, there is a risk that changes to tax relief means this benefit may not last forever, Aegon has warned.
Mr Cameron commented: “While the Chancellor didn’t increase Income Tax rates in his Budget, he did freeze the thresholds when people start paying basic and higher rates of income at the levels for 2021/22.
“The Office for Budget Responsibility (OBR) forecast shows this could mean 1.3 million extra people start paying Income Tax and one million will become higher rate taxpayers.
“This is based on relatively conservative assumptions around future earnings growth of between one percent and two percent a year.
“Many people may have been relieved to find that the Chancellor in his Budget didn’t push up rates of Income Tax, as per one of the Government’s manifesto commitments from 2019.
“Instead, in what’s being called a ‘stealth tax’, the thresholds at which people start paying basic and higher rate Income Tax will be frozen at their 2021/22 tax year levels until April 2026.
“While that might not seem a big deal, according to the OBR it could mean over the next five years, one million people will find that because of even modest increases in their earnings, they will start paying higher rate Income Tax.
“In England this will mean those whose earnings cross the threshold of £50,270 will pay 40 percent on earnings above this, twice the basic rate of 20 percent.
“For them, an increase in the basic rate from 20 percent to say 22 percent might no longer look so bad.
“The OBR makes assumptions above average increases in earnings in future years of between one percent and two percent.
“If you’re earning over £46,442 and you received two percent pay increases for the next four years your earnings would be above £50,270 and you’d become a higher rate taxpayer.
So, how does this relate to pension planning? Mr Cameron explained the aforementioned estimated one million people could avoid the higher rate tax via pension contributions.
“If you’re one of those estimated million people where a much needed pay rise means you face paying higher rate tax, one way to avoid this is to pay more into your pension,” he said.
“Your pension contributions get ‘tax relief’ at your ‘highest marginal rate’. The way you actually get this varies but effectively, if you’re a higher rate taxpayer, it costs you £600 ‘net’ for every £1000 going into your pension.
“That’s a much better deal than basic rate taxpayers for whom it costs £800 net for every £1000.
“The way tax relief works has always made pensions particularly attractive for higher rate taxpayers.
“There were rumours ahead of the Budget that the Chancellor was considering changing the rules, so everyone, whatever their income tax rate, would receive the same tax relief at 25 percent. This would have been good news for basic rate taxpayers but would have given higher rate taxpayers less of a boost.
“The Chancellor didn’t introduce this change, but that’s not to say he might not return to it in future Budgets.
“So if you are already a higher rate taxpayer, or if you find that the freeze on thresholds means you become one in future years, it might be worth considering paying more into your pension, and getting higher rate tax relief while you still can.
“There can be additional benefits in doing so for those in receipt of Child Benefit.”