As you might or might not know, I have recently started a new job. And with new jobs int he UK comes enrolling into company pension and deciding exactly how much to put in it. Company pensions for the most part are simply a contribution schemes where money is taken directly from your payslip before tax and sent to a pension scheme where it accumulates until you are 55 or over. Your employer will usually also contribute, with the lowest required contribution being an equivalent of 2% of your pre-tax income. While this article will not explain the UK pensions concept to you, I am going to explain how and why I am using the opportunity to send more money into my pension as a tax-reducing mechanism.
Workplace pension and salary sacrifice
Legally, your employer is required to enrol you into the pension scheme they offer. You can opt out, but no matter how tight the money is, I strongly recommend that you do not opt out. Once you are enrolled, you can continue paying the minimum contributions i.e. 2% which your employer will match resulting in an equivalent 4% of your salary per month being stashed away for your retirement while it costs you just 2% to sent it there. And you can also opt to set up so called salary sacrifice where a bigger chunk of your pre-tax salary is sent to your pension.
Let’s start with taxable income
Depending on how much you earn, your income is taxed in accordance to a tier system. You can find tiers details on the Government website. The tax is being taken out of your income through PAYE if you are a payroll employee, in addition to national insurance. The idea of salary sacrifice is relevant in context of tax, because it is removed from your income before the income is taxed. This means that your taxable income is reduced by the amount you ‘sacrifice’ to your pension. As a crude example let us say that your salary is £24,000 per year NET. This means that your monthly salary equates to £2000 before any taxes are taken. We are assuming that you are not yet contributing to your pension and therefore the £1,046.67 is tax free, however the remaining £958.33 is subject to 20% tax. Your £2000 therefore turns into a £1813.33 take-home. Separately to this tax you will also pay National Insurance (rates here). The cost of National Insurance on your £2000 monthly salary would be £240, reducing your take-home further to £1573.33. In addition to you paying your national insurance, your employer will also pay additional contribution based on your tax code.
The key word is pre-tax
What happens if you decide to use the salary sacrifice option? Now this ‘sacrifice’ is not a real sacrifice, you’re sending money into in essence an investment portfolio and rather than thinking about how much you’ll miss it, you can think about how much it can generate for you through compounding interest by the time you retire. The money remains yours but is not at your direct disposition (i.e. you can’t just transfer it back into your current account and spend it, but you can move it into different scheme or even a different type of pension plan if you want to) until you reach the age of, currently in the UK, 55 at which you can start drawing money out of your pot.
Let’s be very adventurous and say that instead of opting out of your workplace pension you want to be rich when you’re 55 and opt for 25% pension contribution. In terms of numbers this means that out of your £2000 per month, £500 is sent to your pension directly, reducing the taxable income to £1500. Now with your taxable income down, you still pay no tax on £1046.67 and you still pay 20% on the remaining £500 (20% = £100) and you still pay 12% NI rate on the total (£1500 * 12% = £180). Your gross income has reduced from £1573.33 to £1266.67, but you have also saved £500 this month into your pension. If you were to save £500 into a regular savings account without using the salary sacrifice, your gross income would end up being £1573.33 – £500 = £1073.33. That’s £193.34 or accessible money less to play with compared with a scenario where you your £500 saving is made tax free.
The other NI
Reducing your taxable income through salary sacrifice is not just financially beneficial to you in terms of pension savings. It also carries financial reduction for your NI contribution also reduces. Some employers chose to, as a standard, push that ‘saved’ money they would otherwise pay to the HMRC back into employee’s pension through a mechanism commonly called ‘NI topup’. It is not compulsory for them to do so, but do not be ashamed to nudge the HR or payroll officer and request it in case they’re not doing it already.
And what about private pensions?
You might be aware that if you have a private pension pot outside of your workplace pension through an accredited pensions company, when you pay into it you receive a tax relief on top of the payment. This relief is usually at 20%, however if you happen to be in one of the higher tax tiers, you are able to claim additional relief through your annual tax self-assessment, or by simply calling HMRC. You can find the specific instructions on the Government’s website.
But that if I can’t afford big contributions?
The big question is, for many people not whether to opt in for company pension but what percentage of their income to lock away until they reach 55 years of age. The example I used for a £2k salary is a relatively naive one – most people on that income will find it hard to part with the £300ish additional cash they would have in their pocket if they were not sending the £500 to pensions as living on such income will be challenging for independent adults. However, if you are in position to send at least some money towards your retirement without suffering significantly, there is a plethora of financial evidence for doing it. In order to calculate what that % you commit might be, you can calculate it by reverse-engineering from the amount you need to bring home to meet your basic living needs.
The challenge with this reverse-engineering is that living costs can change and sometimes we are not great at budgeting. However, assuming that you know exactly how much you need to live on, the maths would follow this logic:
Let’s say I need £1400 to live on and my pre-tax pay is £2000.
£1046.67 is tax free accordingly to current tax tiers. However, the amount of £353.33 (£1400 – £1046.67 = £353.33) will be taxed at 20% (£353.33 * 20% = £70.67). In addition to this tax you also need to consider NI for the whole amount of £1400 which is at 12% (£168).
Now with figures to hand, out of the £2000 we will remove the £1400 which we need to live on, the £70.67 in tax and £168 national insurance resulting in £361.33 which would be the amount we’d send to our pension tax-free. That’s roughly 18% of the £2000 pre-tax income. Over the course of the year your pension savings would grow to £4336. That’s a significant amount and if you happen to be relatively young, say 25 years old, by the time you reach 55 years of age this small amount growing conservatively at 4% per year would multiply to net you somewhere around £13,500 without you doing so much as to lifting a finger. If you continue contributions on the exactly the same level for the next 30 years of your career, you’d end up with just short of quarter of a million by the time you retire in addition to state pension. Given that most portfolios net significantly higher profits, I hope I have sufficiently convinced you to get going on your pension now.