In our weekly series, readers can email in with any question about retirement and pension savings to be answered by our expert, Rachel Vahey, head of public policy at investment platform AJ Bell. There is nothing she does not know about pensions. If you have a question for her, email us at money@theipaper.com.
Question: My wife earns £20,000 a year and she salary sacrifices 50 per cent of her salary as additional voluntary contributions (AVCs) into her local authority defined benefit (DB) pension and therefore avoids tax and National Insurance.
We do this so that the AVC’s and DB pots count as one and she can build up a 25 per cent tax free sum and take an annual DB pension.
As her AVC’s are £10,000, does this mean she’s only permitted to put £6,000 in her separate personal pension, which will be the maximum tax relief?
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Answer: As a couple, you have already taken some key decisions on funding more for your later life.
Let’s start with your wife’s current pensions. She is a member of a local government pension scheme. This, as you say, is a defined benefit scheme which means when she retires, she will receive a scheme pension income which is based on her salary and how long she has worked for the local authority. She will also have the option to take tax-free cash from her main scheme by taking a lower income. For each £1 of annual income she gives up, she can take £12 tax-free cash.
Alongside this main scheme, local government pension schemes, like other defined benefit pension schemes, offer ways of building up additional benefits. This could be additional years of pension or an invested pot of additional voluntary contributions (AVCs), where employees decide how the money is invested.
Some local government pension schemes offer a salary sacrifice or salary exchange AVC – known as a shared cost AVC (SCAVC) arrangement.
Employees can choose to exchange part of their salary to be paid directly by their employer into the SCAVC. This benefits the employee by exempting the exchanged salary from national insurance contributions, as well as from tax. The employer also saves national insurance contributions as well.
Employees can choose to take part or, possibly, all of their AVC pot as tax-free cash instead of reducing the income from the main pension scheme. This may make more financial sense. However, the tax-free cash they can take is limited to 25 per cent of the value of the overall pension benefits (both the main scheme and the AVCs).
The downside to salary exchange is that you end up with a lower salary. This may be relevant if you are claiming state benefits or for other financial agreements. However, local government employees’ main pension benefits will still be calculated assuming the full salary.
Salary exchange arrangements cannot reduce an employee’s gross salary to below the National Minimum Wage (NMW) or the National Living Wage (NLW).
One final thing to note; the government plans to limit pension salary exchange for national insurance contribution savings to £2,000 starting April 2029. That gives those currently exchanging more time to consider, with their employer, what adjustments to make.
Your wife can choose to make other personal pension contributions. Here, the tax relief works differently to the occupational pension scheme. Any contributions paid to a personal pension or a self-invested personal pension (Sipp) are paid out of taxed income.
HMRC then makes a tax relief payment direct to the pension scheme. For example, if someone paid £80 to a Sipp, the government tops it up by £20 to make £100.
There are two main rules which calculate maximum pension contributions. The first is individuals can only contribute up to 100 per cent of their UK earnings, including any tax relief. Remember to also include any contributions to the main pension scheme as well.
For example, someone earning £10,000 a year who is already paying £1,000 a year pension contribution to an occupational pension scheme, could pay in an additional £7,200 to a Sipp. HMRC would add in an additional £1,800.
The second rule is the annual allowance, which is usually £60,000 (although it may be lower for very high earners or those who have flexibly accessed their defined contribution pension pots). The £60,000 limit includes all contributions made to a personal pension, including any tax relief received.
Importantly, it also takes into account the increase in benefits built up in a defined benefit scheme that tax year, as well as any contribution paid to AVCs.