Recent research from Aegon showed that, in the event of a surprise £5,000 bonus, 70% of people would prefer to save for the future or pay off debt than spend the money on themselves or loved ones. But can how clients receiving a bonus can make the most of it?
If a client is lucky enough to get a bonus they will no doubt be making plans for what to do with it. That is, until it hits their bank account and the sum staring back at them is far smaller than expected, says Clare Stinton, head of workplace saving analysis, Hargreaves Lansdown.
The reason for the unexpected sum, she explains, is Income Tax and National Insurance nibbling away at the edges meaning that a basic rate taxpayer receiving a £5,000 bonus would only take home £3,600 of it.
Rather than hand over a bigger chunk of their hard-earned cash to HMRC, clients should consider using their pension to keep more of what they earned. If not in need of the cash, choosing to pay some or all of a bonus into a pension offers tax savings, and it will “supercharge retirement” in one tax-smart move – a win-win for the client’s present and future finances, Stinton says.
Four ways a pension can offer the best home for a bonus:
1. It can prevent income going up a tax bracket
Thanks to income tax bands being frozen at 2021/22 levels, millions of people have been pulled into higher tax brackets and are paying more tax. With total earnings over £50,270 a client will find themselves paying 40% tax on anything above the threshold. Above £125,140 the tax rate jumps to 45%.
Effectively this is 60% tax for any money that falls within the range of £100,000 -£125,140. That’s 40% income tax combined with the gradual loss of personal allowance at a rate of £1 for every £2 earned over £100,000. Contributing to a pension can turn this tax trap to the client’s advantage with every £100 in this earnings bracket that goes into your pension costing just £40.
2. Keep more of what’s been earned
Bonuses are taxed in the same way as salary which means a hefty chunk could be deducted before it is seen. One way for a client to keep more of what has been earned is to transfer some or all the bonus to a pension as soon as the money lands in the account. It’ll be topped up with 20% basic rate tax relief automatically by your pension provider, and any higher rate taxpayers can reclaim an additional 20-25% from HMRC via their tax return.
Most earners can pay up to £60,000 into a pension each year, though tax relief is limited to 100% of earnings. However, carry forward enables people to take advantage of any unused allowances from the previous three years, which could enable them to contribute as much as £200,000 to their pension this tax year, assuming their income is sufficient, Stinton says.
3. Bonus sacrifice
The third way, if offered by an employer, is bonus sacrifice provides, which can give “even more powerful tax savings”, Stinton points out. Like salary sacrifice, this method saves both the income tax and National Insurance on pension contributions. It can offer tax savings of up to 47% (62% if the bonus falls into earnings between £100,000 – £125,140).
Bonus sacrifice can also help a client stay within thresholds for state benefits like Child Benefit. If sufficient is contributed a pension to downslide from the higher rate tax band to the basic rate. This will unlock access to an increased personal savings allowance, as well as reduced tax rates on capital gains and dividends.
4. Boost to retirement planning
The earlier any money is deposited into a pension, the sooner it can be invested and the longer it has to potential to grow tax-free, Stinton points out.
“Take a bonus sum of £3,000 that’s been sacrificed into a pension, if it achieves 5% investment return annually, after 5 years this grows to £3,829, after 10 years it’s £4,886, and after 20 years it’s added £7,959 to the pension. Let’s remember, had the £3,000 bonus been paid out to a basic rate taxpayer, they would have received a maximum of £2,160 (20% income tax and 8% National Insurance).”
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