A significant portion of the population remains unaware that boosting pension contributions can lead to a reduction in their income tax bill and unlock other crucial savings, according to recent research. This strategy can potentially increase retirement wealth while also keeping taxable income below critical thresholds.
By increasing pension contributions, individuals may find themselves in a lower income tax bracket. This is particularly relevant as tax thresholds are frozen until 2031, meaning more people are being pulled into higher tax brackets. For higher-earning parents, this can also enable them to continue receiving child benefit and free childcare hours.
If an employer offers a salary sacrifice scheme, where wages are diverted directly into a pension, employees can also save on National Insurance contributions. Standard Life, a financial services firm, conducted a poll of 2,000 adults, weighted to represent the UK population, which found that 52% do not realize the benefits of pension contributions in reducing taxable income.
"It’s widely understood that pensions are designed to help fund your retirement," said Mike Ambery, retirement savings director at Standard Life. "However, far fewer realize the valuable role they can play in wider financial planning. There are a number of scenarios in which it may make sense to sacrifice some of your pay in exchange for a pension contribution."
Tax Thresholds and Personal Allowance
Increasing pension contributions can help individuals fall into a lower income tax bracket. A key issue highlighted is the reduction of the tax-free personal allowance once earnings exceed £100,000. For income above this threshold, the personal allowance is reduced by £1 for every £2 of adjusted net income over £100,000, and it is completely lost at £125,140. This can result in higher earners facing an effective tax rate of 60% on that portion of their earnings.
Child Benefit and Childcare Support
Reducing one's salary through pension contributions can help maintain eligibility for child benefit, which is currently £27.05 per week for the eldest child and £17.90 per week for each additional child. This benefit is available for children under 16, or under 20 if they are in approved education or training.
Since 2013, child benefit has been subject to withdrawal for higher earners. Initially, this applied to families where one parent earned between £50,000 and £60,000. From April 2024, this threshold was adjusted to incomes between £60,000 and £80,000. If a household's adjusted net income exceeds £60,000, the High-Income Child Benefit Charge begins to reduce the benefit, and at £80,000, the full amount of child benefit received is clawed back.
Eligibility for government-funded childcare, such as the 15 or 30 hours of free childcare for working families, can also be affected by income. If either parent has an adjusted net income above £100,000, the household can lose eligibility. Ambery cautioned that this creates a significant cliff edge where a small income increase can lead to substantial rises in childcare costs. Parents should also check their eligibility for the Government's Tax-Free Childcare scheme, which can also be influenced by income, particularly for those paying for nursery or other childcare services.
Salary Sacrifice Schemes
Salary sacrifice schemes allow employees to exchange a portion of their wages for an equivalent pension contribution. This arrangement benefits both employees and employers by reducing National Insurance contributions. Beyond NI savings, the increased pension contribution can also lower an individual's taxable income.
The government plans to cap monthly contributions made through salary sacrifice schemes that do not incur National Insurance at £2,000 from April 2029. However, employees whose employers offer these schemes can still make uncapped contributions for the time being.
Ambery emphasized the importance of understanding how pension contributions interact with the tax system, stating that "more than half of people aren’t aware of the power of pension contributions when it comes to reducing their taxable income." He also noted that frozen tax thresholds mean that a pay rise does not always result in families being better off, as earnings can quickly tip into higher tax rates than anticipated.