Contributions to Pensions has two advantages. Firstly, contribution to registered pension schemes is tax free and secondly the growth the scheme attributes is also tax free. Pension income is taxable when the taxpayer retires. Even then it leads to a win-win situation as an individual will have less taxable income at that stage therefore the tax rate will normally be lower.
Similarly, charitable gifting also has two positives. One, it is benevolent and helps the underprivileged and second is the tax advantage. Charitable gifts are also a win-win situation and give a warm glow from knowing one has also helped a charity in need.
It is interesting to know that contributions to pensions and charitable gifts will lead to a reduction in the income tax payable by an individual there by significantly reducing the tax bill. HMRC pays the 20% tax to the charity, and adjustments being allowed to the basic, higher, and additional rate bands, allowing the donations to be made tax-free to higher and additional taxpayers too.
Who can save tax by pension and charitable donations?
Taxpayers having an ‘adjusted net earnings’ more than £100,000 can save income tax by making pension contributions or charitable donations. It is important to know that once an individual has received an adjusted net earnings of £125,140 or above, he will no longer be eligible for personal allowance.
‘Adjusted net earnings’
‘Adjusted net earnings’ is the sum of the taxpayer’s net income from all sources, such as employment income, rental income, income from bank and building society deposits and returns from holding stocks and shares, such as dividends. This total income is then reduced by the gross amount of any pension payments or gift aid payments in the tax year. Therefore, more contributions and gifts result in less adjusted net income thereby allowing taxpayer to avail personal allowance.
Ruth earns a salary of £110,300 in 2022/23. She has not paid any pension payments or gift aid payments. Her personal allowance is reduced by £5,150 as she earns over £100,000. (Example shown below).
Further to the above example, Ruth had paid £4,000 to the Red Cross, a registered charity, and £4,240 to her private pension scheme. Although her salary is still mostly taxed at 20% and 40%, as she has adjusted net income which does not exceed £100,000, she is entitled to her personal allowance in full.
Ruth has saved £6,180 of tax by paying these additional amounts into her pension and to the charity.