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Maximise your pension and save tax

By Raymond Mulligan

Q: I am shortly to receive a lump sum as part of a voluntary severance package. I have been told that I can invest a portion of this in my AVC pension pot, and then reclaim the money thereby triggering some sort of tax saving. Can you clarify the situation?

A: To answer your question we will have to rewind the clock almost three years. In April 2006 the whole of the pensions legislation altered as a result of what was known as ‘A Day’.

A Day came about in an attempt by the government to simplify pensions and ultimately encourage more people to take responsibility for planning their own retirement.

A Day saw the demise of Additional Voluntary Contributions (AVCs), Free Standing Additional Voluntary Contributions (FSAVCs), Personal Pensions, Executive Pensions and a list of other pension types.

What replaced these was one generic type of pension that was simple to understand.

Gone were the varying funding limits and differing tax free cash allowances, and in its place came a pension that allowed individuals to fund up to 100% of their salary, and at retirement provide a tax free lump sum of 25% of the fund.

So if you have or are about to receive a lump sum as part of a voluntary severance package, then it is possible to fund all or part of this into a pension arrangement.

As I stated earlier, the limit to which you are entitled to make a contribution will be a maximum of up to 100% of your salary.

Whether or not you pay as much of this will depend upon your overall objectives. Issues such as having a sufficient emergency fund, particularly relevant if you are likely to be out of work for a period of time.

The other issue to consider when calculating how much you should contribute from the lump sum, is your tax position. The benefit of a redundancy payment is that the first £30,000 is payable as a tax free lump sum.

Using part or all of this to fund a pension can therefore be very advantageous. Any contribution you make will be invested net of basic rate tax, irrespective of your tax position.

In essence this means that if you were to invest a sum of say £8,000 from your severance package, the life office that you invest with will automatically add a further £2,000 which equates to basic rate tax relief.

Of this £10,000 investment, if you are a higher rate tax payer, you can claim your higher rate tax relief, which can amount to a further £2,000.

This is normally given as either a tax rebate, or an adjustment to your tax code. Careful consideration should be given therefore to your overall earnings in this tax year, in order to ensure that you maximise the tax breaks offered by the government.

There is an additional incentive to funding a pension via the likes of a severance package if you are currently aged over 50.

At present this is the age at which you can access any pension fund and makes the investment extremely tax efficient. If you take the figures we used above, a higher rate tax payer who makes a contribution towards the pension can achieve the following:

  • Individual contributes £8,000 net to a pension
  • Individual reclaims £2,000 additional higher rate relief
  • Individual accesses £2,500 tax free cash allowance immediately

This means that for an effective contribution of £3,500 the individual has accumulated £7,500 in a pension plan.

As ever however, I would recommend that you take some independent advice to ensure your tax breaks are fully maximised

Raymond Mulligan is managing director of Johnston Campbell, a company of independent financial advisers regulated by the Financial Services Authority. For further information, please contact or (028) 9022 1010

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