Salary sacrifice into pension can be attractive for clients but we must watch out for annual allowance issues, says David Little, Partner in Financial Planning at leading UK wealth management firm Evelyn Partners.
It’s bonus season for hundreds of thousands of white-collar professionals, executives and C-suite leaders across the UK. In the City of London, bonuses are more highly anticipated than they have been for several years as not only was 2025 a bumper year for markets and banking profits but also bonus restrictions for bankers have been relaxed for the first time the financial crisis. Bankers in the UK will now receive bonuses faster and might also receive more bonus-heavy pay packages.
In a loosening of rules imposed on pay after the 2008 financial crisis, the Bank of England last cut the proportion of bonuses that must be deferred, and the time senior bankers must wait before receiving full bonuses from eight years to four years. Leading investment banks are also reportedly reducing fixed allowances in favour of larger bonuses.
While many bonus recipients might be wary in the current uncertain economic climate of splashing out on big-ticket items like new cars, some highly paid professionals and executives will also not have the tax-efficient option of sacrificing their bonus into a pension due to the restrictions and complexities of the tapered annual allowance. In this situation, very high earners might well take their bonus as taxed income but then save it, invest it or even gift it to family.
For some, the various pressures on household finances, mortgage refinancing costs as low fixed rate deals roll off, as well as the possibility of job insecurity given the uncertain outlook in some sectors, mean that splashing a bonus on big-ticket luxury items might be off the menu. Others might decide some late-winter sun or time on the ski slopes is the most therapeutic use of the extra cash. Of course, it depends on what sort of sum we’re talking about – a large bonus can be put to more than one use.
Having a bonus paid into a pension is usually the most tax-efficient use of a payout, and those who have access to salary sacrifice schemes should remember that the clock is ticking on this valuable benefit as a £2,000 annual cap on salary sacrifice pension contributions announced in the last Budget is due to arrive in April 2029.
But for the highest earners – including City of London bankers – that option will be nullified by the tapered annual allowance which, above certain pay and income thresholds, drastically reduces the amount that can be paid into a pension with tax relief to as little as £10,000.
Even those bonus recipients with plenty of annual allowance remaining could decide that the best use of their extra payout is to pay down the mortgage or other debts, add to savings or to fund expenses like home renovations or private school fees that have soared following the inclusion of VAT on them last year.
Depending on an employer’s bonus arrangements, client’s might be able to opt for some to be paid into their pension and take the rest as taxed income.
Pay down mortgage or other debt
Unsecured debts on credit cards or loans should generally be the first port of call for a lump sum, but assuming these are not an issue, for many it will be paying down a mortgage, especially if they are about to roll onto a higher rate.
Timing is a bit of an issue as borrowers with some time to go on a fixed rate deal will find they cannot just pay down the loan, by more than 10% anyway, without an early repayment charge.
In that case, finding a tax-efficient home for the funds (such as an ISA), until the mortgage term expires is a good call. This option could be especially appealing for those concerned about job security heading into 2026 as lower monthly mortgage commitments will make the prospect of redundancy less intimidating.
For families with children in private schools the imposition of VAT last year on fees that had already risen significantly in previous years could mean that the bonus goes on clearing this soaring expense.
The tax issue
Without any alternative action, a bonus payout will simply be added to a client’s annual taxable income and be taxed at their marginal rate.
As income tax thresholds are in the middle of a long-term freeze, which by the process of fiscal drag is increasing the tax burden across all income levels, mitigating exposure to tax on a bonus will be the priority for many.
Frozen thresholds mean the number of people being drawn deeper into the higher rate of tax is rising rapidly, and the lower threshold for paying the 45 per cent additional rate (reduced from £150,000 to £125,140 in April 2023) has also drawn in hundreds of thousands more professionals with higher salaries.
Many high earners will also be conscious that a bonus payment could take them up the steep marginal tax step at £100,000 in earnings. This is the point at which the tax-free personal allowance starts to be tapered away, resulting in a 62 per cent effective marginal tax rate on the band of income between £100,000 and £125,140 – as well as the loss of significant childcare support.
Bonus sacrifice or contribution into pension
The most straightforward tax-saving move is to use some or all of a bonus to make a pension contribution, as this will provide income tax relief at at a client’s marginal rate. This means someone who is a 40 per cent taxpayer can make a gross pension contribution of £10,000, for a net cost of £6,000, once the tax relief is factored in.
But remember there are restrictions on when your client can start accessing their pension – this is currently age 55 but due to rise to age 57.
Workplaces with salary sacrifice systems make this option even more appealing and straightforward. Instead of receiving a bonus as taxed income, opting to forgo it (or some of it) in lieu of a company pension contribution. With prior instruction, a gross bonus will simply go straight into the pension, providing relief against National Insurance as well as income tax – and the possibility of an additional contribution from the employer’s NI saving. This option could be especially beneficial for those earners nudging up against a higher tax band or the big marginal rate step at £100,000.
Such tax savings really are compelling and after the announcement at the November Budget that there will be a £2,000 cap on salary sacrifice from April 2029, for many of those who currently benefit from this system it will make sense to “grab it while you can”. Most HR/payroll departments at firms with salary sacrifice arrangements will send out a request for individuals to choose whether they want to do this before the award is granted. If your client is unsure as to whether their employer can accommodate a bonus sacrifice, they should speak to the relevant department as soon as possible.
If that chance has passed or salary sacrifice is not available, they can still obtain tax relief by putting it into a pension personally as they will still benefit from income tax relief, and for those near the £100,000 marginal tax step this can also help by reducing “adjusted net income”. Higher and additional rate pension tax relief seems to come up before every Budget as a target for the Treasury to boost revenues, and it can’t be taken for granted that these tax benefits will be around forever.
If subject to the higher or additional rates of income tax, it is vital to proactively claim the tax relief that individuals are are eligible for, whether that is by self-assessment or direct to HM Revenue & Customs.
However, all bonus recipients intending to add a lump sum to a pension must watch out for the annual allowance, which for most will be £60,000, as well as the limit of their relevant earnings. If the earner has been contributing significant amounts all year, then sums must be done to avoid unexpected tax bills, and it’s not always straightforward so professional advice is recommended here.
Tapered annual allowanced
The highest earners could be closed off from this tax-efficient option. Those with a “threshold income” over £200,000 can face a big disadvantage in pension saving because the amount of tax relief they can claim is usually limited by the tapered annual allowance.
The tapered annual allowance kicks in when “adjusted income” rises above £260,000, which includes income from all sources, as well as any employer pension contributions. Those subject to the taper see their AA reduce by £1 for every £2 they exceed £260,000, until those earning £360,000 and above will have the minimum AA of £10,000.
This means they are very restricted in the amount of tax-relieved contributions they can make into a pension, at just a sixth of the amount of those not subject to the taper.
ISAs
Saving or investing outside a pension might be an attractive option for many in the current economic and financial environment. They might not want to blow their payout on a treat but neither might they want to lock it away for a decade or more in an inaccessible pension pot.
While ISAs won’t enable clients to recoup the tax they’ve paid on a bonus, they will protect future returns from taxation and securing ISA allowances only becomes more important as the tax burden on income, interest and capital gains grows. Pensions have the edge when it comes to upfront tax relief, but ISAs win for flexibility where withdrawals can be made at any time, and returns are tax-free on the way out whereas pension withdrawals outside of the 25% tax-free entitlement are potentially taxable.
There is some anecdotal evidence that faith in pensions has been dented by repeated speculation that Governments could water down existing tax benefits such as the option to withdraw 25 per cent tax-free cash (which has already been capped). Some individuals are preferring to save more into ISAs rather than pour everything into the restricted environment of a pension.
Even those who have used up their ISA entitlements and either can’t or don’t want to put their bonus into a pension might still want to save or invest their bonus rather than spend it. One strategy we have been talking to clients about more often since the most recent Budget is offshore bonds. These can offer certain protection against some of the rising tax burden on savings and investments outside of tax wrappers.
Venture Capital Trusts and Enterprise Investment Schemes
Another way to use a bonus to cut an income tax bill is to subscribe to a Venture Capital Trust or Enterprise Investment Scheme new share issue. Both schemes provide investors with tax incentives to encourage investment into fledgling UK trading companies that meet certain rules.
EIS involves direct investment into an individual small, unquoted business, whereas VCTs are specialist investment companies – akin to investment trusts – that invest in a portfolio of small UK growth companies which are either unquoted or issuing shares on the AIM market. Both EIS and VCTs are therefore specialist and higher risk investments focused on illiquid companies and are not suitable for most investors.
The Government does however provide a range of tempting tax perks, which can be attractive to sophisticated investors who have exhausted limits on tax wrappers like pensions and ISAs.
When investing in an EIS or VCT new share issue, individuals can claim a 30% income tax credit off the sum invested (via a tax return), meaning a £10,000 subscription will enable to lop £3,000 off an income tax bill for the year the shares were allotted. VCT shares, which are listed on the London Stock Exchange, must be held for a minimum of five years to keep the tax credit and in the case of EIS the required holding period is at least three years – though as these are private companies, there is no certainty that clients will be able to sell their EIS shares in such a timescale.
Once invested, any dividends or gains from VCT shares are tax free, whereas EIS shares are free from CGT and after two years qualify for Business Relief which potentially exempts them from an estate for Inheritance Tax purposes.
It should be noted that following the last Budget, the income tax credits available on VCTs will be cut to 20% from April, reducing their future attractions, but there is still time to benefit from the higher relief available this tax year and plenty of VCTs are currently raising new money ahead of this change. Up to £200k can be invested in VCT share issues this tax year, netting a maximum income tax credit of £60k, providing the client has such an income tax liability.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
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