Pension payments and gifts to charity

Meg Saksida explains how payments into registered pension schemes and to charities can reduce your income tax bill. 

Pensions are a wonderful thing. Not only are contributions made by individuals to registered pension schemes tax-free, but once the funds are in the scheme, growth inside the scheme is also tax-free. Although pension income is taxable once the taxpayer is retired, usually, the individual will have less taxable income at that stage in life and therefore be taxed at a lower income tax rate on the pension savings being paid out. It’s a ‘win-win’ situation. 

Likewise, charitable gifting is also a delightful pursuit. Not only is it benevolent and of great help to the many and varied deserving charities out there, but like pensions, with HMRC paying the 20% tax to the charity, and adjustments being allowed to the basic, higher and additional rate bands, allowing the donations to be made tax-free to higher and additional taxpayers too. Charitable gifts are also a win-win situation and give a warm glow from knowing one has also helped a charity in need. 

However, in addition to the benefits above, contributions to pensions and donations to charity can, for some taxpayers, actually reduce the amount of income tax that a taxpayer needs to pay. And depending on the contributions and the specific taxpayer, this can be a significant tax saving. 

Who can save tax by pension and charitable donations? 

Taxpayers able to save income tax by making these contributions or donations are those that have ‘adjusted net earnings’ in excess of £100,000. This is because, for every £2 a taxpayer’s adjusted net earnings is over £100,000, they lose £1 of their personal allowance.  

It stands to reason, then, that once the individual has received adjusted net earnings of over £125,140, they will no longer be eligible for any personal allowance. 

What is the definition of ‘adjusted net earnings’? 

‘Adjusted net earnings’ are made up of the taxpayer's net income from all sources, such as employment income, rental income, income from bank and building society deposits and returns from holding stocks and shares, such as dividends. This total income is then reduced by the gross amount of any pension payments or gift aid payments in the tax year.  

The more pension payments and gift aid payments a taxpayer has, the more the adjusted net income reduces, and the more it reduces closer to £100,000, the more personal allowance the taxpayer is eligible to. 

Example: The effect on adjusted net earnings 

Molly earns a salary of £110,300 in 2022/23. She has not paid any pension payments or gift aid payments. Her salary is taxed entirely at 20% and 40% as she earns over £100,000 and so is not entitled to the personal allowance.

Suppose that Molly had, instead, paid £4,000 to the Red Cross, a registered charity, and £4,240 to her private pension scheme. Although her salary is still mostly taxed at 20% and 40%, as she has adjusted net income which does not exceed £100,000, she is entitled to her personal allowance in full. 

Molly has saved £7,088 of tax by paying these additional amounts into her pension and to the charity. 

Practical tip 

Where a taxpayer’s salary is just over £100,000, consider whether it is worth making either a gift aid or a pension contribution to reduce the adjusted net income and reinstate the personal allowance.