Annual bonuses and pension contributions, the perfect match

Understandably, the temptation for many employees to spend a bonus on luxury items or home improvements may be high. However, the immediate tax advantages of pension contributions may persuade many to at least consider paying some into their pension where they can afford to do so.

Bonus payments can be subject to very high marginal rates of income tax along with national insurance. A large bonus can also, unexpectedly, tip someone into a higher tax band, push them into the “personal allowance trap” or even mean they become subject to the high income child benefit charge. Making pension contributions with some or all of the bonus can then offer very effective tax planning.

Some employers will offer bonus sacrifice and this can be the most efficient method of making pension contributions. As well as the tax savings, the employee will also save on the national insurance contributions. In addition, some employers may be willing to pass on some or all of their national insurance savings. Most bonus schemes are discretionary rather than contractual and, because of this, there is often no need to have a formal “bonus sacrifice” arrangement. It will, however, need the employer’s agreement to implement this, and any agreement needs to be made before the bonus is paid.  

If the employer is not willing to offer bonus sacrifice, then personal contributions can still be a very beneficial option. The employee will pay national insurance on the bonus payment, but will receive income tax relief. The contributions will also reduce adjusted net income, which can be important for ensuring income remains below key thresholds.

One of the highest effective rates of relief can be where a bonus would otherwise take an individual over the £100,000 personal allowance threshold. As well as any income being subject to 40% income tax, the personal allowance is reduced by £1 for every £2 of income above £100,000. The full personal allowance is lost where adjusted net income is £125,140 or higher. This means, where an end of tax year bonus takes the employee into this bracket, the effective rate of tax relief can be 60%, or even more if bonus sacrifice is used.

Employees will need to have sufficient pension allowances available to make the contribution. Relevant UK earnings are unlikely to be an issue in this situation, as bonuses will be taxed in the same way as other earnings and so be classed as relevant UK earnings for the purposes of making tax relievable personal contributions. The annual allowance is more likely to be the restricting issue. If the employee has already used up their full annual allowance for the current tax year, they can look back to the three previous tax years to see if there are any available allowances to carry forward. Any carry forward available from 2019/20 will be lost if it is not used by 5 April 2023, so it’s worth seeing if any employee clients have scope to use up that with their end of year bonus.

For very high earners, a larger than expected bonus can cause complications when it comes to pension planning. If regular or previous single contributions have already been made on the assumption that the employee’s annual allowance wouldn’t be tapered, or it would only be tapered to a certain level, a larger bonus can mean they have inadvertently over funded their pensions by paying in more than their available annual allowance. Unfortunately, in this situation, all they can do is pay the annual allowance charge. Many schemes are now offering voluntary scheme pays in this type of situation, which can ease the immediate burden. However, where high earning employee clients receive discretionary bonuses, it is best to take a cautious approach to pension funding.

For those who are able and willing to forego their bonus now, and have sufficient pension allowances available, using the bonus to make a pension contribution can be a very effective form of financial planning.