Leon is a commodities trader with a basic salary of £120,000. His annual bonus can double his income, but most years it is far more modest. The company tells him about the bonus in October each year. He always contributes the full Annual Allowance to his pension on a monthly basis, for the past few years this has been a net payment of £2,666 which is grossed up to £3,333 by the government.
He understands that making a monthly contribution improves his investment returns because of the effect of ‘pound cost averaging’. Each month his payment is used to buy units in his chosen investments. When markets are down Leon gets more units for his money than he would do if markets were rising.
Restrictions for higher earners
The Annual Allowance tapering rules mean that anyone with total income over £150,000 has their Annual Allowance reduced by £1 for every £2 over the £150,000 limit. The tapering is capped at £210,000 so the minimum Annual Allowance is £10,000.
Leon won’t know until October what his total income for the year will be, so at the start of the tax year he doesn’t know how much he will be able to contribute to his pension. If his bonus is more than £30,000 he will definitely have a reduced Annual Allowance, but if he waits until October to make a pension contribution he won’t get the benefit of pound cost averaging or any growth in the market in this period.
He knows he will be able to pay at least £10,000 into a pension so he sets up a monthly payment of £666 net of tax into his SIPP (£833 gross).
Making the most of tax-efficient savings and investments
Leon uses his pension & ISA allowance every year, but he doesn’t currently use his Capital Gains exemption. He decides to save £2,000 each month into a General Investment Account and switch the money into his pension in October when he will know what he can save into a pension.
In October he finds out his bonus is £45,000, giving him total income of £165,000 for the year. His tapered Annual Allowance is therefore £32,500 (his income exceeds £150,000 by £15,000. £15,000 / 2 = £7,500 reduction to his Annual Allowance).
As Leon has already contributed £10,000 to his SIPP, he can pay in a further £22,500 gross or £18,000 net of tax. After making seven payments totalling £14,000 Leon’s GIA is worth £18,519, a gain of £4,519. He encashes the whole GIA to make his pension contribution. There is no tax to pay because the gain is within the annual capital gains allowance.
Because Leon continued to make contributions on a regular basis, rather than waiting for his bonus then paying in a lump sum, he benefited from market growth between April and October. His net contribution of £18,000 only cost him £13,481 (he has £519 left over in the GIA).
Leon also benefits from higher & additional rate tax relief on his gross contribution worth £7,250. After adding together the investment growth and the tax relief his gross contribution of £32,500 actually costs £14,750.