Pensions and Capital Gains - Harmonising your Tax Planning

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    Pensions and Capital Gains – Harmonising your Tax Planning

    Throughout 2021 there was increased speculation that, in order to finance the hefty fiscal stimulus provided over the past 2 years, the government would look to make changes to what can broadly be referred to as ‘wealth taxes’ i.e. capital gains tax and inheritance tax.

    Strike while the iron is hot!

    One such proposal by the Office of Tax Simplification (OTS) was to align capital gains tax with income tax and slashing the tax-free annual exemption. However, as of December 2021, we seem to have been granted a reprieve and the historically low capital gains tax rates of 10% and 20% (18% and 28% for residential property) continue to be available to those with assets or portfolios abundant with capital gains. The big question is how long will it last?

    Without attempting the futile task of predicting the future, it could be argued that any CGT changes over the coming years will be in an upwards direction rather than downwards. So it makes sense that planning to reduce the impact of future gains should start now while we are in a period of low CGT rates.

    There are several ways in which you can mitigate or minimise a capital gains tax liability from taking advantage of your (and your spouses) annual exemptions, utilising previous losses and even potentially utilising investments into Enterprise Investment Schemes (EIS/SEIS).

    However, where gains are above the annual exemption (£12,300 in 2021/22) and there are no losses to offset, one often overlooked option is using pension contributions to minimise your capital gains tax liability.

    A brief introduction to pension tax relief

    Many of us will be aware of the usual benefits of pension when planning for a person’s retirement. Income tax relief is available at an individual’s highest marginal rate up to their relevant UK earnings (generally earned income not pensions, rental or dividends).

    For higher earners, tax relief is claimed in two stages; firstly basic rate tax relief of 20% is received automatically within the pension scheme. For example, where an individual makes a net contribution of £8,000 to their pension, the provider claims £2,000 basic rate tax relief resulting in a gross contribution of £10,000.

    Higher and additional rate taxpayers get further relief through their self-assessment tax return as the result of a pension contribution is an extension of their basic and higher rate bands by the gross up contribution. In effect, part of their income moves from the (higher rate) 40% bracket into 20%, and (additional rate) 45% into 40%.

    What does this have to do with Capital Gains?

    When a capital gain exceeds the annual exemption (£12,300 in 2021/22), the surplus is added on top of an individual’s income. Any part of the gain that sits within the basic rate band is taxed at 10% and the balance at 20% (for residential properties, 18% and 28% rates apply).

    In the same way as higher and additional tax relief above, pension contributions can be used to extend your basic rate tax band increasing the amount taxed at the lower 10% rate.

    As the below example illustrates, for an individual at, or close to the higher or additional rate threshold, a pension contribution can pull the income into the basic rate band.

    No Pension Contribution (£)Gross Pension Contribution (£)
    Earned income50,27050,270
    Gross Pension Contribution0-10,000
    Taxable Gains10,00010,000
    Income Tax7,5405,540
    Capital Gains Tax2,0001,000
    Total Tax Payable9,5406,540

    Furthermore, the net pension contribution required to pay is only £8,000. So, not only has this individual saved £1,000 in CGT tax, but they have also received relief on the pension contribution of £2,000 – an effective rate of tax relief of 30%.

    As well as the usual benefits of providing for a person’s retirement, the above example shows that pension contributions can also be a valuable tool in your wider tax planning.

    So as we approach the tax year end, if you have significant capital gains and want to explore how pensions or alternative tax strategies can work better for you, please don’t hesitate to get in touch.

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