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Salary Exchange, Pension Contributions and Child Benefit

A reminder of the pension planning opportunities for higher earners from January 2013

Background

The Chancellor confirmed in the Budget that there will be a tax charge for individuals with income over £50,000 if they or their partners are in receipt of child benefit. If both partners have income of more than £50,000 for the tax year, the charge will apply only to the partner with the highest income.

These new rules started on 7th January 2013.

HMRC have written to higher rate taxpayers, explaining how these rules work and giving them the option of receiving the child benefit and being liable for a tax charge through their self-assessment tax return or opting not to receive the child benefit.

A better option is to continue receiving the child benefit and reduce your income so that you are no longer liable for a tax charge.

Removing the liability to a tax charge

For taxpayers whose income is between £50,000 and £60,000, the charge will be 1% of the amount of child benefit for every £100 of income that exceeds £50,000. A taxpayer whose income exceeds £60,000 effectively loses all the advantage of child benefit.

However, for the tax year 2012/13 the child benefit tax charge will only apply to the child benefit paid between 7th January 2013 and 5th April 2013. Although the income for the full tax year will be used to calculate the tax charge.

The following example is to illustrate the savings to be made for future tax years when the child benefit tax charge will apply to the child benefit received over the complete year.

Example

John is married and has two young children for whom John and his wife receive child benefit of £1,752 p.a. John has income of £55,000 – so his tax charge will be £876 (50% of £1,752) i.e. £17.52 for every £100 earned above £50,000.

The measure of income used will be the individual’s ‘adjusted net income’. This is an existing method of determining an individual’s income and is currently used to work out entitlement to a personal allowance for someone who has income over £100,000.

It is the definition of ‘adjusted net income’ that will enable clients to use salary exchange to save this tax charge. This is because ‘adjusted net income’ excludes salary exchange, pension contributions and gift aid amongst other things. So by exchanging salary and receiving a pension contribution a client will also benefit by saving this tax charge.

So let us consider what would happen if John exchanges £5,000 of his salary. His income is therefore reduced to £50,000. The monthly equivalent is £416.67.

If John took the salary he would pay the following tax and NICs. So by exchanging it he would save the same amounts.

2012/2013
Earnings 416.67
Income tax (at 40%) 166.67
National insurance (at 2%) 8.33
Net pay 241.67

This would give the following savings to the employer:

2012/2013
Reduction in salary 416.67
National insurance saving (at 13.8%) 57.50
Total employer saving 474.17

The employer would then pay the £474.17 into a pension plan for the member.

The monthly equivalent of the saving in child benefit tax charge is £73 (£876 / 12).

So by sacrificing monthly gross income of £416.67 John has saved 40% income tax, 2% NICs and 13.8% employers NICs and a child benefit tax charge.

The total saving is £166.67 + £8.33 + £57.50 + £73 which gives £305.50.

This gives an effective savings rate of 73.3%

For these examples we have assumed that the employers will include their NIC savings in the pension contribution. However some employers may want to keep some or all of their savings and this will need to be borne in mind when discussing any improvement.

This method will work better when someone is starting salary exchange from the beginning of the tax year but may be difficult for clients to sacrifice enough to offset the charge altogether. They could still reduce the charge by sacrificing a smaller amount.

In addition the client could reduce the ‘adjusted net income’ further by making a personal pension contribution. This will still be tax-effective although not as effective as salary exchange.

Summary

Salary exchange as a concept has been with us for many years and the relative effectiveness alters depending on the changes to the national insurance rates and the bands to which the NI rates apply. With the increase in the NIC rates in April 2011 and the introduction of the child benefit tax charge, we expect salary exchange to remain as popular as ever.