The 60% income tax trap*

It is widely believed that the highest income tax rate is currently 45%, paid only on an income in excess of £150,000. While this is true, some people may actually have an effective tax rate of 60& on part of their income.

Case study: salary increase over £100,000

Caroline has had a successful career as a shipping lawyer and has reached a salary of £100,000.  She was delighted to learn that she was being promoted to a salaried partner with a 10% increase in her pay. However, the issue is that for every £2 she earns over £100,000, she will lose £1 of her personal allowance (so once her salary reaches £125,000, she will have no personal allowance). The following table illustrates the impact this has on her net pay:

The table shows that although Caroline’s pay has increased by £10,000, her tax has increased by £6,000, which is an effective tax rate on this top element of her pay of 60%.  This is triggered by the 40% tax on the lost personal allowance.

As Caroline is now earning more than £100,000, HMRC will also require her to complete a tax return.

As a solution, Caroline can make an additional pension contribution. If her employer’s pension scheme is a group personal pension and Caroline pays a net pension contribution in the tax year of £8,000, then with the addition of basic rate tax relief, this will increase to a payment into her pension of £10,000. Her “adjusted net income” will reduce to £100,000, so she will get back her personal allowance, and her basic rate band will grow by the amount of the contribution. Therefore, we now has the following tax rates:

Caroline pays £4,000 less in tax, but also receives the £2,000 top-up to the pension contribution, so the overall effect is an additional payment into her pension of £10,000 and a saving in tax of £6,000  (a 60% tax relief).

If her employer’s pension scheme is a trust-based scheme, then the payment of pension contributions are generally deducted before the calculation of tax. Therefore, paying a £10,000 contribution in the tax year effectively puts her tax position back to how it  was before the pay rise.

Alternatively, Caroline may be able to use salary exchange to give up the pay rise, in return for the employer making the additional contributions into the pension scheme. The additional benefit of this approach is the additional saving of National Insurance contributions, which on a sacrifice of £10,000 would be an additional saving of £200.

Case study:  discretionary bonus payment

Patrick is a Managing Associate earning £95,000. He has had a very busy year working on some major clients of the firm, giving great client service and advice; so the firm decides to reward Patrick for his exceptional performance by paying a discretionary bonus of £15,000.

As a result, Patrick will now earn £110,000 in the tax year, and therefore faces the same issue as Caroline.

The table shows that although the firm has paid Patrick a bonus of £15,000, he will pay an additional £8,000 in tax (an effective tax rate of 53.3%).

Again, a possible solution for this is for Patrick to make an additional pension contribution. This is achievable through a bonus sacrifice, and as the bonus is discretionary, this would simply need to be agreed at the time the bonus is being discussed.  If Patrick sacrificed £10,000 of his bonus, his pay would reduce to £100,000 and his tax will be as follows:

Consequently, Patrick has additional net income of £3,000, but in addition, an extra contribution in his pension account of £10,000 and a saving of £200 in National Insurance costs. Overall, a total value of £13,200 and effective tax rate of 12%.

These case studies illustrate how tax-efficient pension contributions could help you achieve more at this pay point in situations where the loss of personal allowance increases the effective tax rate.

For more information, don't hesitate to get in touch with a member of our team.

Robert J Young  BSc FIA E Robert.Young@hanover-group.com

*These examples are fictional, but the content is based on various, real client experiences.

Firstly, Happy New Year to you all. I hope that you managed to have an enjoyable and restful festive period.

The FTSE 100 index increased

To start this market review with some good news, over the course of December the FTSE 100 index increased by 4.6%, which saw it reach its highest level seen since February 2020. Looking at 2021 as a whole, the index finished the year 14.3% higher. To put this in perspective, this was the best performance over a calendar year since 2016. Of course, this is good news for those investments that we look after with a stocks and shares element. 

Having said this, at the start of December the news of the Omicron variant saw the markets wobble, with concern over how this may affect investments. At this time, there were fears over how contagious this variant was, and the governments across the UK brought in fresh restrictions. This caused a degree of concern on how this would affect the already struggling hospitality and leisure sectors.

The inflation and the consumer price index continued to rise in the UK

Inflation has continued to increase in the UK and the annualised rate of consumer price inflation rose to 5.1% in December, driven largely by continuing high costs for transport and energy. The Bank of England’s (BoE) Monetary Policy Committee somewhat surprisingly increased the base rate to 0.25% from its historical low of 0.10%, a move that was expected in November. The surprising element was not the increase, but the timing, as earlier in the month, the BoE had warned of the impact that the Omicron variant could have on the UK economy. It is widely expected to continue tightening its policy measures over 2022.

In the US...

Much like the UK, all the major global equity markets saw increases during 2021. The Dow Jones Industrial Average Index in the US closed December 5.4% higher, and saw an annual increase of 18.7% over the year.

Again, as was seen in the UK, inflation continued to surge in the US, led by energy and food prices rising. Their consumer price inflation rose to 6.8% during November, a rate not seen in the US since 1982. There is now expectation that the Federal Reserve will look to increase interest rates during 2022, with some policymakers forecasting anything up to four rises.

In the Eurozone...

The Eurozone was no different, as high energy prices affected the annualised consumer price inflation that rose to 4.9% in November. However, the European Central Bank continues to see the current inflationary pressures as a temporary issue, caused by the global pandemic. In Germany, the Dax Index went up by 5.2% during December, and closed 2021 15.8% higher.

We hope that 2022 sees an end to the restrictions when it is safe to do so, and we finally return to a sense of normality. As always, if you have any questions in regards to your current investment portfolio or any other financial planning matter, please do get in touch with us.

Richard Brazier Director E RichardBrazier@hanoverfm.co.uk

Who should you contact for more information?

Director Richard Brazier

Financial Adviser Amanda Beacon

Senior Consultant Graham Smithson

This case study demonstrates how clients can use SSASs to save for their retirement in a flexible, tax-efficient manner, to compliment and assist their business operations.

Setting up the scheme

Keith and Mick own a successful manufacturing business. They operate out of a commercial building that they lease from an unconnected third party. Their landlord approaches them and offers first refusal on the purchase of the building.

Keith and Mick have various options opened to them to purchase the property:

• They could purchase the property themselves, with their personal funds;
• They could purchase the property through their company; or
• They could use a pension fund to purchase the property.

The pension fund route is their preferred option due to tax savings. Keith and Mick consider setting up either (a) two SIPPs (Self-Invested Personal Pension) to purchase the property together or (b) an SSAS to purchase the property. They decide to set up an SSAS (Small Self-Administered Scheme) for the following reasons:

• The complexity of owning the property over two SIPPs, with two associated borrowings, was pushing up the costs of operating the SIPPs;
• They are keen on the option a SSAS has to make loans to the sponsoring employer of the scheme; and
• They know they will act as trustees of the SSAS and will therefore retain more control over their retirement benefits when compared to the SIPP route.

Consequently, they set up an SSAS, with the help of an Independent Trustee to assist them with compliance with the relevant HMRC rules.

Purchasing property

Keith and Mick transfer their existing pension arrangements into the new SSAS. They also make sizeable employer contributions to the scheme, which qualify for tax relief within the company.  They are still short of the purchase price, so the trustees arrange bank borrowings to assist with the purchase.

The property is purchased and the trustees are now acting as the landlord, with the sponsoring employer the tenant. An arms-length commercial lease is put in place to define the terms on which the property is let to the company. However, the company are now paying rental income to their pension fund instead of to the unconnected third party.

Using SSAS - early years

The trustees use the rental income to service the borrowings, and  any surplus is retained in the scheme and invested in a portfolio of quoted investments, managed by a discretionary fund manager.

After a few years, the borrowings have been repaid. Accordingly, all the rental income paid to the scheme is boosting the investment portfolio. The rental income and capital growth soon generate a sizeable investment portfolio, sitting alongside the property as the two main assets of the scheme.

Making employer-related investments

Keith and Mick’s business is doing well, but they have cashflow issues and need to borrow money to keep the business moving forward. They discuss their options with their Independent Trustee and  decide to borrow funds from their SSAS instead.

A loan is granted over five years, with the employer paying back interest and capital to the pension fund throughout the term of the loan. Keith and Mick feel this is a much better source of funding for the company, as they are paying interest to their pension fund rather than to a bank.

Drawing benefits

As Keith and Mick get older, they bring their children into the family business to help with the day-to-day operation of the company. Their children also join the SSAS, so can benefit from the greater returns they achieve from pooling their modest pension savings with those of their parents.

Keith and Mick are drawing less income from the company, so both decide to draw benefits from the SSAS. Although Keith and Mick are members of the same scheme, this does not mean they have to draw the same retirement benefits. Keith requires a large lump sum, so draws the maximum tax-free lump sum andcommences drawing a pension, whilst Mick decides to phase his benefits and spread his tax-free lump sum payments over a number of tax years.

While Keith and Mick are drawing benefits, their employer is still funding their pensions by paying their rental income into the scheme. Keith and Mick can choose to draw modest pensions, roughly equal the rental income, or draw greater amounts and use some of the capital held in the investment portfolio as well as rental income. The speed at which they draw benefits is entirely up to them under the flexi-access drawdown rules.

Passing benefits onto other family members

Sadly, Mick passes away. The trustees of the scheme can use the remainder of Mick’s fund to pay death benefits. These benefits are split equally between his wife and his four children, who are each allocated a pot within the scheme, equal to 20% of Mick’s remaining funds. Benefits are paid at the discretion of the trustees.  The SSAS now sits outside of Mick’s estate and is free of IHT when these benefits pass to his wife and children.

As Mick passed away before age 75, the trustees are therefore able to offer these benefits to the beneficiaries tax-free.  All five beneficiaries are able to make independent decisions as to what they do with their own pot.  One decides to draw everything out tax-free in one go, another decides to draw a tax-free pension from the scheme each month, while the other three decide they do not need any income at present, so they decide to wait to draw any benefits until they’re required

Passing property to the next-generation 

Keith and Mick’s children have been running the business successfully for some time now and have outgrown the building owned by the pension fund. They find a larger site for relocation and they decide to liquidate the investment portfolio within the pension fund and obtain bank borrowings to acquire this new commercial property within the pension fund.

They consider letting out the old building to an unconnected third party. However, in the end they decide to sell the original property. As the trustees have held onto the property for so many years, the value is far greater than the original purchase price.

However, the trustees do not pay Capital Gains Tax and therefore the wholesale price is paid into the pension fund. The trustees decide to use these funds to pay off the borrowings required to purchase the second property and invest the residual funds in the investment portfolio.

For more details on SASS pension, please don't hesitate to contact a member of our team.

*These case studies are fictional, but the content is based on various, real client experiences.