Child benefit and pension contributions

Child benefit can be taken for granted. But it can also be taken away. Where someone in the household earns more than £50,000, the benefit begins to be withdrawn by way of a tax charge. This could mean losing out on £2,475 for a family with three children.

For individuals in this situation, the solution could be as simple as making a pension contribution. And for some, the effective tax relief on their contribution could be as much as 77%!

With the tax year end fast approaching, there’s no better time to consider this opportunity.

How it works
The tax charge starts to bite when the income of the household’s highest earner reaches £50k. But this test isn’t based on ‘income’ as most people think of it. It’s based on ‘adjusted net income’. This is:

  • the individual’s total taxable income from all sourcesless
  • their own pension contributions (gross amount) – amongst other deductions.

So individuals can flex the rules and get their child benefit tax back by paying into a pension.

What it means – the bottom line
Eliminating the child benefit tax effectively increases the tax relief on an  individual’s pension contribution. And if the contribution is funded using salary (or bonus) sacrifice, with the employer NI saving reinvested in the pension, the results will be boosted further.

Just look at the effective relief on a £10k gross pension contribution by an  individual on £60k:

No. of kids 1 2 3 4
£10k contribution 50.7% 57.7% 64.8% 71.8%
£10k sacrifice 58.4% 64.6% 70.8% 77.0%

Case study – couple with 2 kids, dad on £60k a year, non-working mum
Hannah and James have two children under the age of 16. Hannah stays at home to look after the kids, and gets child benefit of £1,770 a year (£20.50 a week for the eldest child; £13.55 for the youngest).

James works, and also has savings income from shares and bank deposits. His income for 2014/15 is:

Net Gross
Salary   £57,000
Deposit interest £400 £500
Dividends   £2,250 £2,500
Adjusted net income £60,000

The child benefit tax charge he’ll suffer completely cancels out the £1,770 child benefit claimed by Hannah. Note that Hannah still gets the child benefit, but James must account for the tax charge through self-assessment.

But if James pays £8,000 (net) to his Self Invested Personal Pension (SIPP), his adjusted net income becomes:

Net Gross
Salary £57,000
Deposit interest £400 £500
Dividends   £2,250 £2,500
Less: SIPP contribution £8,000   £10,000
Adjusted net income £50,000

This means that James no longer suffers the child benefit tax charge. And he’ll have received 40% tax relief on the SIPP contribution too. So the net cost of adding £10,000 to his SIPP is only £4,230 (£10,000 – £4,000 – £1,770). You could say this is an effective rate of tax relief of over 57.7%.

It gets even better if James’ employer agrees to pay the SIPP contribution by salary sacrifice. This means changing his employment contract to reflect a lower salary plus an employer pension contribution. But it’s worth the hassle:

  • James still saves £5,770 tax, but now also saves £200 in NI (£10,000 x 2% employee NI on earnings above the UEL).
  • And his employer saves £1,380 NI as well (£10,000 x 13.8% employer NI).
  • If his employer agrees to pay this NI saving into James’ SIPP, he’ll have £11,380 added to his pot for a net cost of just £4,030 – an effective rate of relief of 64.6%!

If done by salary sacrifice, this could mean that James doesn’t need to complete a tax return for 2014/15 – another saving in itself.

Summary
A pension contribution won’t be the right solution for all those caught in the child benefit tax trap. Some will need the boost that child benefit gives their monthly spendable income, despite the tax charge. But for those who want to build their retirement savings in a tax efficient way, the opportunity is clear.

 

Source: Standard Life