Acumen Financial Planning pensions specialist Kevin Mackenzie explains how those people who are lucky enough to receive a new year bonus can make it go further
Are you in line for a bonus in early 2015? If you don’t need the money in your pocket today, it would be sensible to invest it for the future.
A pension fund remains the most commonly-used vehicle for those saving towards life after work. This is because a pension contribution attracts income tax relief, investment growth is tax advantaged and 25% of the fund can be extracted free from tax from age 55. Sounds good, doesn’t it?
There is a way to make such an investment even more attractive to both you and your employer: salary or bonus exchange.
Such an arrangement is beneficial because both employee and employer will pay reduced national insurance contributions (NICs). The NICs savings can be recycled back into the pension fund and a pension contribution larger than the bonus can be paid at no extract cost to the employee or employer.
Let’s take an example: Alan has a basic salary of £75,000 per annum. Having exceeded his targets his employer has offered him a £10,000 bonus. If this was paid directly to Alan, it would be subject to income tax at 40%.
Alan’s NICs at 2% would be £200, giving a net bonus of £5,800, and his employer would also pay NICs at 13.8%, which would be £1,380.
But if the bonus was paid to Alan as a pension contribution, there would be no NICs liability. The combined NIC saving of £1,580 could be added to the pension contribution, resulting in a total pension contribution of £11,580 rather than a net bonus of £5,800 – effectively doubling the value of the bonus.
Alan and his employer must have a written agreement in place before a bonus sacrifice arrangement is put in place.
Salary or bonus exchange can be particularly useful for people earning more than £50,000 a year, who are liable for a child benefit tax charge, as it could effectively reduce their income to below this threshold.
For those earning in excess of £100,000 per annum, salary or bonus exchange arrangements could increase their personal allowance – the tax-free element of earnings. And for those eligible for working tax credits, this benefit could be enhanced if earnings are reduced.
The main benefit, however, is to put some of today’s money aside for the future so that you will one day reach financial independence – a stage in life where you have sufficient savings and investments that working becomes a choice rather than a necessity.
Tax planning in conjunction with retirement income planning is complex but with careful planning there are tax breaks available.