Today I want to share with you a tax “hack” that can save you a lot of money. I’m really grateful to a good friend of mine, a tax accountant, who told me about this. As the title suggests, the hack is increasing your child benefit entitlement with pension contributions. In this post, I’ll explain exactly how to do it.
Before you read any further:
– If you AND your partner both earn less than £50k a year, this will probably not be relevant for you.
– If you OR your partner earn more than £100k a year, this may not be relevant for you either.
– Please consult a tax professional as each person has their own individual circumstances.
As parents pursuing FI, every penny counts and compounds. That’s why optimising your pension contribution is a very important decision. Clarification: My workplace pension is a defined contribution where the contributions are paid from gross (before tax) salary. The information below relates to this kind of pensions.
On the one hand, the more you contribute to your pension, the less you have today. In addition, I’m planning on reaching FI in my early 40’s (see the February 2021 update here). Therefore, having money locked up until I’m 60 (57 based on today’s rules but I guess it will increase) is less than ideal. That’s 15-20 years from the moment I can potentially retire until the moment I can access this money.
On the other hand, from a tax perspective, the benefits are huge! My marginal income tax rate is 40% and my marginal national insurance (NI) rate is 2%. This means that for every £100 I contribute to my pension, my net (after-tax) salary decreases by only £58 (£100 gross-£40 income tax-£2 NI). This means that in order to get £100 into my personal pension, I only have to “give up” £58 of my net salary.
“But wait, you’ll pay tax on this amount when you retire” I can hear some of you saying. That’s correct, but a lot less.
I wrote a whole post about taxes in retirement (link). I’ll link to it again throughout this post for your convenience (so you don’t have to scroll back up). In short, I explained why I use a 0% tax rate in my own retirement calculations. I did, however, also explain why I understand people who use an 8.75% tax rate. For the purpose of this post, let’s be prudent and use 8.75%.
Compare that to the 42% marginal tax rate you pay on that money if you don’t contribute it to your pension. This is a 33.25% saving by contributing to your pension!
“OK, that’s clear, but what’s that got to do with child benefit”
Currently (March 2021), the full child benefit is £21.05 a week, which is £1,094.60 (21.05 * 52) a year for the first child. This equates to £91.22 a month, let’s call it £91 for convenience.
If both parents’ income is less than 50k each in a tax year, you should get full child benefit. This is because it’s calculated based on the parent with the higher income.
If one of the parents has an income of over 60k in a tax year, you will get nothing. Actually, you can still get the child benefit but you’ll have to repay it.
What about people with incomes between 50k-60k in a tax year? They will get partial child benefit with every £100 income over 50k reducing child benefit by 1%.
Example: If a parent has an income of 57k, this means they earn 7k over 50k. 7k/100=70, meaning their child benefit will be reduced by 70% and will therefore only be entitled to 30% of the full child benefit.
“OK, that’s clear too, but how has that got anything to do with pensions?”
Aha, now we get to the interesting part.
The great combination
How does HMRC calculate your income?
They add your gross salary and a few more items (like interest, dividends and a few more). Then, they deduct a few items including pensions contributions. This means you can increase your child benefit entitlement with pension contributions!
See for yourself with HMRC’s child benefit calculator:
Scenario 1: If you or your partner both earn less than 50k a year each
I will assume here that both partners have no other income and no other allowable expenses, or that even after including those- none of them pass the £50k. In this case, you are already entitled to 100% of the child benefit. This means you can’t increase your child benefit entitlement with pension contributions.
Scenario 2: If you or your partner (whoever earns more) earn between 50k and 60k a year
We’ll use a couple where the higher earner earns £57k a year. Again- assuming that parent has no other income and no other allowable expenses. As explained above, without contributing to a pension, that parent is only entitled to 30% child benefit.
No pension contributions:
If they contribute nothing, their annual net salary will be £41,700. They will get £328.38 (1,094.60 * 30%) in child benefit for that year and nothing goes to pension.
Total: Net cash is £42,028.38 and nothing to pension.
Contributing enough to get income down to £50k
If they contribute 7k (12.28% of gross) to their pension, their annual net salary will be £37,640. They will get £1,094.60 in child benefit and 7k goes to a pension. We’ll assume this will be taxed at an effective tax rate of 8.75%, leaving £6,387.50, which is (1-8.75%) * £7,000.
Total: Net cash is £38,734.60 and £7000 to pension which will be taken out as £6,387.50.
This means that by contributing 7k gross to their pension, this parent:
1. Had a decrease of £4,060 in net salary but gained £766.22 (1,094.60 – 328.38) a year in child benefit thanks to the increased pension contributions. In total, this parent had a decrease of £3,293.78 today.
2. Gained an extra £7,000 in pension which we will treat for this example as £6,387.50
Total gain: £3,093.72
Scenario 3: If you or your partner (whoever earns more) earn more than 60k and can reduce your income to below £60k with pension contributions.
If you or your partner earn more than 60k then your first pension contributions, those that get you down to 60k, will “only” save you the difference between your marginal tax rate (42% up to 100k) and the tax rate you’ll pay in retirement, 8.75%. This is a saving of 33.25%. The rest (getting below £60k until you hit £50k a year) will save you more as you start gaining entitlement to child benefit as well.
We’ll use a couple where the higher earner earns £75k a year. Again- assuming that parent has no other income and no other allowable expenses. As explained above, without contributing to a pension, that parent is not entitled to any child benefit as they earn more than £60k a year.
No pension contributions:
If they contribute nothing, their net salary will be £52,140. They will get £0 in child benefit for that year and nothing goes to pension.
Total: Net cash is £52,140 and nothing to pension.
Contributing enough to get income to £50k
If they contribute 25k (33.33% of gross) to their pension, their net salary will be £37,640. They will get £1,094.60 in child benefit and 25k goes to pension. Again, this will be taxed at an effective tax rate of 8.75%. This leaves £22,812.50, which is (1-8.75%) * £25,000.
Total: Net cash is £38,734.60 and £25,000 to a pension which will be taken out as £22,812.50.
This means that by contributing 25k gross to their pension, this parent:
1. Had a decrease of £14,500 in net salary but gained £1,094.60 in child benefit a year. The £1,094.60 is the increase in child benefit thanks to the pension contributions. In total, this parent had a decrease of £13,405.40 today.
2. Gained an extra £25,000 in pension which we will treat for this example as £22,812.50
Total gain: £9,407.10
Scenario 4: If you or your partner (whoever earns more) earn more than 90k and can’t reduce your income to below £60k with pension contributions.
Currently (March 2021) the maximum you can contribute to pension is £40k a year and sometimes you can contribute more (if you contributed less than £40k a year in previous years). This means that if you (the higher earner) earn less than £100k a year, you can get child benefit entitlement using pension contribution. In addition, if you earn less than £90k you can use this method to get full child benefit.
However, if you are a very high earner (greater than £100k a year) and can not reduce your income below £60k a year using pension contributions then:
1. Good for you for being really successful in your career/business! That’s amazing.
2. Unfortunately, the method above will not be relevant for you.
Assuming you earn £60k – £100k a year, each £100 you contribute until you get your income down to £60k will save you £33.25 in the long run. This is the difference between your marginal tax rate (42% as explained above) and the rate we use for pension, 8.75%.
Once you get to the 50k-60k range, each £100 additional contribution costs you £58 net but it does increase child benefit thanks to the pension contribution. The child benefit increase is 10.94 (1,094.60*1%), meaning your income today is decreased by £47.06. However, you gain an additional £100 in pension. We treat it as £91.25 (due to a drawdown tax rate of 8.75% as explained above).
Total gain: £44.19.
As you can see, there is a triple benefit here to pension contributions:
1. you only pay tax on 75% of your pension withdrawal. Explained in detail here.
2. If you withdraw less than you earn today, you will pay lower tax even on your taxable 75%. We used an effective tax rate of 8.75%
3. You can increase child benefit with pension contributions by getting your income below 60k a year.
If a Lazy FI parent earns more than £50k, I would highly recommend thinking about contributing enough to their pension in order to get their income to 50k and enjoy the full child benefit. That’s what I consider “the sweet spot” from a pension contribution perspective.
Do you consider child benefit entitlement when you decide how much to contribute to your personal pension?
A few important notes:
– Make sure your net salary will be enough before you increase your pension contributions. It is not worth going into debt for.
– There are limits to how much you are legally allowed to contribute to your pension. This method may not be relevant for you if you or your partner earn more than £100k a year.
– Some employers will match your pension contribution. This makes a 4th benefit- free money for your pension and your future self.
-If you have more than one child, the full child benefit is even higher. This makes the pension contribution increases even more attractive.
– If you plan on withdrawing less than £30k a year from your personal pension (after withdrawing the 25% tax-free lump sum) after retirement, the effective tax rate will be even lower than %8.75. This makes pension contributions even more attractive.