Redundancies are an unfortunate consequence of current times, and with the government’s furlough scheme changing, there may be more employers who will need to make cuts to their workforce.
How paying into a pension can help
It might seem counter intuitive to make a pension contribution at a time when easy access to cash is a priority; however, this could deliver better financial outcomes if there are other assets that could be used to cover current income needs.
The tax-relief on pension contributions make them the most tax-effective way of saving for retirement. A £20,000 contribution to pension savings comes at a net cost of £12,000 for a higher rate taxpayer, or £16,000 for a basic-rate taxpayer. This might be even more, if extra savings can be made where the personal allowance is restored or child benefit can continue from making a pension contribution.Potentially, more can be paid into a pension in a single tax year than the next best home, an Individual Savings Account (currently £20,000), particularly in the year of receipt of a redundancy package.
Reducing tax rates and reinstating allowances
Making a pension contribution, whether as a personal contribution, or an employer contribution through salary sacrifice, will reduce tax rates paid on total income, perhaps from 45% to 40% or from 40% to 20%. It also reduces an individual’s ‘adjusted net income’ (ANI), perhaps reinstating the personal allowance, which on its own, is worth £5,000 to a higher rate taxpayer.
The same is true for child benefit. If ANI can be reduced to £50,000, this could wipe out the child benefit tax charge, which could be worth an extra £2,500 for a family with three children.
Pension funding by salary sacrifice
Some employers may offer, or agree to a sacrifice on some or all of the redundancy payment. The advantage is that employer pension contributions are not normally subject to National Insurance (NI) at 13.8%, and they may be willing to pass this saving on to the employee. Therefore, it makes sense to make the sacrifice from those parts of the redundancy payment that are subject to NI in the first instance. For example, the optimum order may be ‘payment in lieu of notice’ (PILON) payments, (because these are subject to both employer and employee NI), then the taxable part of the redundancy payment for loss of office (because employer NI is due on these).
While the £30,000 tax-free element could be sacrificed, there are no tax or NI advantages in doing so, therefore - it may be better to pay it as a personal contribution.
In particular, higher earners choosing the redundancy sacrifice option can sometimes cause the annual allowance to be tapered, thus restricting the amount that can be paid into pension without incurring a pension annual allowance tax charge. This is because any new sacrifice arrangement is included in an individual’s threshold income. This is in contrast to an individual contribution, as we shall see below.
Pension funding by individual contribution
While you may benefit from NI savings made under a sacrifice arrangement, not all employers may be willing to offer this option. A personal contribution still makes sense, and may even be preferable if the annual allowance would otherwise be tapered.
There are several things to consider when making an individual payment into a pension.
- National Insurance - there are no NI savings to be made, unlike a sacrifice.
- Relevant UK earnings – you must have enough relevant UK earnings to get full tax-relief on the contribution. In fact, most providers will not accept contributions in excess of earnings. Relevant UK earnings are broadly any pay taxable in the UK, including benefits in kind. The taxable part of the redundancy package will obviously boost earnings, and the potential for a large pension contribution. The £30,000 tax-free part of the termination payment, plus dividends, rent, and other savings income, are the main items excluded from relevant UK earnings.If you do not have sufficient relevant earnings (or annual allowance) you could think about making a contribution to your spouse/partner’s pension – provided they, themselves, have the scope to do so.
- Earnings from abroad - earnings not taxable in the UK due to a double taxation agreement will not be included in relevant UK earnings.
- Annual allowance – you must also have enough annual allowance available, otherwise the tax-relief given on any excess will be clawed back through self-assessment. Unused allowances from the last three tax years, can be added to the annual allowance for the current tax year. Receiving a taxable lump-sum on redundancy, can mean that the adjusted income limit of £240,000 is breached, resulting in a reduced annual allowance for the current tax year. To remedy this, an individual contribution may be enough to reduce ‘threshold income’ to below £200,000, restoring the full £40,000 annual allowance. As alluded to earlier this is not possible if the pension contribution is made by sacrifice.
The prospect of redundancy can be difficult time for many people, but equally for some, it can be a welcome cash injection that could mean retirement plans can be brought forward, or savings boosted, if they can quickly find suitable new employment. With the right tax planning, those retirement and savings ambitions could be further enhanced.