Monday, 18 October 2010

How To Save Higher Rate Tax and Keep your Child Benefit

There has been a peculiar unintended consequence to the Government’s new policy on child benefit. For a limited number of people who earn between the current higher rate tax threshold of £43,875 and approximately £47000 to £48000, there is a window of opportunity for people to save both higher rate tax and maintain their child benefit allowance which they would otherwise lose. Consider the following two examples:

John has earnings of £47,500 per annum. Anna his wife does not work and they have two children both of whom are under 18 and at school. Under the old rules, John would receive Child benefit of £1056 on his first child, Jack with a further £697 being payable to his second child Jill.

Under the new rules, John will lose both of those benefits because he is a higher rate tax payer. However, with some forward planning, it is possible for John to retain his child benefits and this is by use of ‘sacrificing’ some of his salary and paying more into a pension plan.

Consider the example as below:

Of John’s current salary, he has to contribute 5% to his company final salary scheme. Because these contributions are deducted through the payroll, this amount is deducted from his salary and reduces his salary from £47,500 to £45,125. Pension contributions are, of course, fully tax deductible.

However, this level is still above the higher rate tax threshold and as such, John would still lose his child benefit allowance. However, if John were to make additional contributions to his pension plan of £1250 gross this would bring his salary down to £43, 875 and he would then get his full child allowance for both children. Of course, he would get full tax relief on his contribution meaning that he would be entitled to a tax rebate of 40% on the contribution (1250 * 40% = £500). This would mean that for John’s pension contribution of £1250 would actually only cost him £750!

Therefore, in this instance, he would get back a further £1753 in child allowance and he would be better off by this amount less the net contribution to his pension (£1753 - £750). So, he would have an additional £1003 in the family budget plus a further £1250 going to his retirement fund of which the Government has contributed £500 in tax relief.

So, it is actually costing the Government £500 in tax Revenues they will not now receive together with the additional £1753 in Child allowance. I’m sure that they did not intend this when they drafted the legislation.