Author Topic: Best way to take advantage of side hustle income (tax efficiency)  (Read 756 times)

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Hi,

Just registered with MMM, and keen to share some discussion. This might be a bit heavy for a first post, but here goes...



Let's say you take advantage of the UK rent-a-room rule as a side earner and that provides you with a nice 7500 additional tax-free income a year.

Let's say you've already paid off your mortgage, have no debts and living frugally, and already embrace living within your means and saving/investing. This nice additional income can really help accelerate path to future financial security.

But how would you best us it? Where would you invest it?

Tell me if this sounds a bit crazy...

Me, I would live off the income from the rent-a-room while at the same increasing the pension contribution from my regular job to the amount where my net income is then reduced by an equivilent 7500/year to take advantage of the income tax relief on pension.

So for someone on 40k gross salary making 0% pension contribution their breakdown would look like this:


40,000 gross
5628.2 income tax
3789.12 NI
---
30582.68 Net


However if they put 23.5% of the gross salary toward their pension, their numbers now look like:

40,000 gross
3,748.20 income tax
3789.12 NI
9400.00 Pension
---
23062.68 Net


Note that they are now able to shield 1880 (ie 5628.2 minus 3748.2) from the tax man from the income tax relief.

Add back the 7500 from the rent-a-room to the lower 23063 net pay and you are back on the same pay that you had before, but now they have a very healthy 9400/year going towards their pension.

What do you think? Is that a smart use of the extra cashflow, or is that taking the idea of delayed gratification too far??



PhilB

  • Pencil Stache
  • ****
  • Posts: 540
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #1 on: January 10, 2019, 11:39:52 AM »
It depends on a lot of factors.  For a basic rate tax payer without access to salary sacrifice if you already expect to be fully using your personal allowance in retirement then it's 20% relief going in but 15% tax coming out so you make only about 470 profit on your 7,500.  Is that a good enough reward for tying up your money until pension access age?  If you expect to FIRE well before that you may have more of a priority on non-pension funds.  If you hope to be a higher rate tax payer you'd be better off parking it in an ISA for now then moving it to a pension later.  If you think they will bring in a higher flat rate of relief then likewise ISA and wait.  If you think that the tax on pensions when you come to take them out may be higher than now then that could sway you.  If you are of an age to use a LISA then that may be better (20% relief in but tax free coming out).
At the end of the day you pays your money and takes your choice.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #2 on: January 10, 2019, 02:43:16 PM »
It depends on a lot of factors.  For a basic rate tax payer without access to salary sacrifice if you already expect to be fully using your personal allowance in retirement then it's 20% relief going in but 15% tax coming out so you make only about 470 profit on your 7,500.  Is that a good enough reward for tying up your money until pension access age?  If you expect to FIRE well before that you may have more of a priority on non-pension funds.  If you hope to be a higher rate tax payer you'd be better off parking it in an ISA for now then moving it to a pension later.  If you think they will bring in a higher flat rate of relief then likewise ISA and wait.  If you think that the tax on pensions when you come to take them out may be higher than now then that could sway you.  If you are of an age to use a LISA then that may be better (20% relief in but tax free coming out).
At the end of the day you pays your money and takes your choice.

Thanks. PhilB. The pension is not the only string in my bow.. I have actually just opened a S&S ISA and am planning to max out the 20k allowance on an ongoing basis. For want of a better explanation, these are not my real numbers... I have a lot of free cash at the moment and mulling where best to put it. I I have a view that cheap monetary policy has inflated most assets and so future returns will be below historical norms. I don't mind lobbing some of it at the pension if it means I can get further tax relief. the lump sum is tax-free too, is it not..? that is provided it is still around when I come to cashing it in.. I have a 20 year time horizon on this.

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #3 on: January 10, 2019, 03:41:31 PM »
It depends on a lot of factors.  For a basic rate tax payer without access to salary sacrifice if you already expect to be fully using your personal allowance in retirement then it's 20% relief going in but 15% tax coming out so you make only about 470 profit on your 7,500.  Is that a good enough reward for tying up your money until pension access age?  If you expect to FIRE well before that you may have more of a priority on non-pension funds.  If you hope to be a higher rate tax payer you'd be better off parking it in an ISA for now then moving it to a pension later.  If you think they will bring in a higher flat rate of relief then likewise ISA and wait.  If you think that the tax on pensions when you come to take them out may be higher than now then that could sway you.  If you are of an age to use a LISA then that may be better (20% relief in but tax free coming out).
At the end of the day you pays your money and takes your choice.

Thanks. PhilB. The pension is not the only string in my bow.. I have actually just opened a S&S ISA and am planning to max out the 20k allowance on an ongoing basis. For want of a better explanation, these are not my real numbers... I have a lot of free cash at the moment and mulling where best to put it. I I have a view that cheap monetary policy has inflated most assets and so future returns will be below historical norms. I don't mind lobbing some of it at the pension if it means I can get further tax relief. the lump sum is tax-free too, is it not..? that is provided it is still around when I come to cashing it in.. I have a 20 year time horizon on this.
You need to separate the investment from the wrapper.  With the exception of residential property the investment options available to you in a pension are exactly the same as those available outside.  You need to think about the two questions separately - what to invest in and which wrapper to use.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #4 on: January 10, 2019, 06:33:10 PM »
You need to separate the investment from the wrapper.  With the exception of residential property the investment options available to you in a pension are exactly the same as those available outside.  You need to think about the two questions separately - what to invest in and which wrapper to use.

That's an interesting way of looking at it.

I do get a 5% employer contribution if I choose the pension wrapper, and I believe the maths of compounding works better if you pay tax on the way out rather than on the contributions which is why I still think the pension option has a lot going for it.

I do get the flexibility to pick what funds my pension is invested in, so from an allocation point of view there wouldn't be any difference.

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #5 on: January 11, 2019, 08:29:45 AM »
You need to separate the investment from the wrapper.  With the exception of residential property the investment options available to you in a pension are exactly the same as those available outside.  You need to think about the two questions separately - what to invest in and which wrapper to use.

That's an interesting way of looking at it.

I do get a 5% employer contribution if I choose the pension wrapper, and I believe the maths of compounding works better if you pay tax on the way out rather than on the contributions which is why I still think the pension option has a lot going for it.

I do get the flexibility to pick what funds my pension is invested in, so from an allocation point of view there wouldn't be any difference.
The 5% employer contribution is definitely worth getting and I would always recommend paying enough to het the max employer contribution.  The compounding works exactly the same whether you pay tax at the start or the end as base x growth x (1-tax) = base x (1-tax) x growth - the only way you get a difference is if the tax rates are different.  Currently, with UK pensions for a basic rate payer that would be 20% taking it now or 15% taking it later (25% tax free, 75% taxed at 20%).  Pensions beyond what is needed for max employer contributions may well still be the best option for you, but do the maths and consciously take a view on things like your future tax position, future tax treatment of pensions both on the way in (flat rate anyone?) and on the way out (Lib Dems proposing a 40k limit for TFLS, tax rates generally may have to increase to pay for elderly care, etc).  If you are struggling to come to a view on those things then parking funds in a S&S ISA using the same investments as you would have used in the pension buys you time to see what happens - I don't think anyone is expecting the tax advantages on the way in to get worse for basic rate payers.

sea_saw

  • Pencil Stache
  • ****
  • Posts: 549
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #6 on: January 13, 2019, 09:06:56 AM »
I believe the maths of compounding works better if you pay tax on the way out rather than on the contributions which is why I still think the pension option has a lot going for it.
The compounding works exactly the same whether you pay tax at the start or the end as base x growth x (1-tax) = base x (1-tax) x growth - the only way you get a difference is if the tax rates are different

Just to illustrate what PhilB said:

Scenario 1, taxed on the way in: You earn 1000. It's taxed at 20%, so you're left with 800. You invest it and it doubles. You now have 1600.

Scenario 2, taxed on the way out: You earn 1000, and invest it. It doubles, so you have 2000. You're taxed 20%, you're now left with 1600.

It all evens out, so long as the rates are the same. The bigger the difference between the rates, the bigger the advantage you're gaining.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #7 on: January 13, 2019, 10:48:11 AM »
Thanks for making that clear. Food for thought.  The pension idea is not quite the massive tax dodge that I dreamt. Unfortunately I'm not quite in the 45% tax bracket, so it seems to be a choice between 20% effective ISA rate or 15% effective Pension rate (with the lump sum stipulation).

I will be doing both, as I believe they both have their advantages, and that with the income my side hustle I can fully meet the 20k ISA limit.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #8 on: January 13, 2019, 11:01:40 AM »
Oh, another thought..
Are you really sure that you will be taxed at 20% on the income from the pension?

Realistically you would need roughly a 200k pension pot or bigger before your annuity starts to exceed the tax-free threshold. Depending on what other investments and incomes you will have, it seems quite likely that the real effective rate you pay across all your retirement income will lower than 20%

sea_saw

  • Pencil Stache
  • ****
  • Posts: 549
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #9 on: January 13, 2019, 01:17:37 PM »
Glad to help. Basically it's multiplication: it doesn't matter which order you do the multiplication in, 1000 * 0.8 * 2 or 1000 * 2 * 0.8, you'll end up with the same results.

Real life finances are fiddlier though :) Yes, you're right, you'll still have your personal allowance in retirement, paying no tax on the first 11k of your income (or whatever it will be by then). That's what PhilB was referring to by: 'For a basic rate tax payer without access to salary sacrifice if you already expect to be fully using your personal allowance in retirement then it's 20% relief going in but 15% tax coming out.'

Quote
Realistically you would need roughly a 200k pension pot or bigger before your annuity starts to exceed the tax-free threshold.

I don't think that's an unusual situation. Definitely not around here ha.

sea_saw

  • Pencil Stache
  • ****
  • Posts: 549
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #10 on: January 13, 2019, 01:24:49 PM »
Incidentally I've just looked it up and it looks like the state pension is liable for income tax. In today's numbers, that would take up up to 6.5k of your personal allowance. So it doesn't take a lot of pension to tip you into paying 20% on it.

(Bear in mind I am not a retirement expert as I'm still miles away - hopefully other folks here will correct if I'm misleading you somehow!).

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #11 on: January 13, 2019, 04:03:02 PM »
Incidentally I've just looked it up and it looks like the state pension is liable for income tax. In today's numbers, that would take up up to 6.5k 8.5k of your personal allowance. So it doesn't take a lot of pension to tip you into paying 20% on it.

(Bear in mind I am not a retirement expert as I'm still miles away - hopefully other folks here will correct if I'm misleading you somehow!).
FTFY.  Single tier pension is 8.5k now so not a lot of PA left once you're drawing it.  For an early retiree though, there is a fair amount of scope to pull out your PA between pension access age and SP age.  As a back of a fag packet calc, say 100k to yield 4k of income to use up remaining PA plus 85k of unused PA for the 10 years you are in drawdown but below SP age comes to 185k.  Gross up for the TFLS gets you to roughly 250k that you can build up in a pension and get back out tax free.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #12 on: January 15, 2019, 03:23:48 AM »
Thanks, yes, the income from state pension is a consideration too, and a 250k private pot is probably good number to aim for become it gets more complicated.

I've actually had a lightbulb moment on this.. I need to convince my WIFE to pay more into her pension, as she is rather comfortably earning in the 40% tax bracket (or at least she will be once her maternity leave ends in April), so we could escape much more tax that way. Even if her pot (oo-er) ends up north of 250k and she has to pay 20% after the TFLS, that's still a 25% tax advantage from the 40% marginal rate on the income.

I usually let her manage her own financial affairs.. she is quite good, but not quite the fanatic that I am.

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #13 on: January 15, 2019, 06:09:13 AM »
As long she will a) not hit the lifetime allowance, and b) not be a higher rate taxpayer in retirement, then contributing her HRT band income beats hands down anything you can get as it's a nearly 42% return (60 in gets 85 out) vs 25% for anything you can get out tax free and 6.25% for anything you take out over your PA.  (And yes I do think that's iniquitous).

daverobev

  • Magnum Stache
  • ******
  • Posts: 3174
  • Location: UK
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #14 on: January 26, 2019, 03:01:55 AM »
Bit late to reply here but anyway.

For me, there are extra reasons to push more into a SIPP over the next few years:

1. I probably won't hit 35 years of State Pension contributions

2. You can take 25% out of a pension tax free at the start.

3. You can start withdrawing ten years before SP age, so there is a chance to pull a significant amount out before SP starts using your PA

4. If you can use Salary Sacrifice (and your company will pass along the NI saving), you are getting quite a chunk above normal

5. Add into that avoiding repaying Student Loans

Now, I'm in an odd situation in that I've moved back to the UK and have nothing in anything the UK sees as a tax sheltered pension, but looking at it has made me realise I should push *everything* into the SIPP for the moment - first through Salary Sac, but even after that I should be pushing what salary I do get in as well because there is plenty of time to pull it out again/plenty of personal allowance - when you factor the massive amount of ISA room each year as well.

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
Re: Best way to take advantage of side hustle income (tax efficiency)
« Reply #15 on: February 14, 2019, 03:56:51 PM »
A further q which I hope someone can help me with if I decide to explore the SIPP route.

Basically, as I understand the pension provider (in my case Fidelity) will automatically top up your SIPP by 20%, so if you pay in 800 you are topped up a further 200 under the assumption of applying basic rate tax relief.

My question is: what if the money you throw into the SIPP is earnt outside of your regular income (eg for the Rent-a-room which I suggested in my OP)? I would presume that you are not entitled to the top-up if you haven't paid any tax on it already. If I throw the 7500 from the rent-a-room into the SIPP, it would be wrong for them to top me up a further 20% on that, wouldn't it? How do you get around this? Do you need to declare it on a tax self assessment and pay it back to the Inland Revenue?

Or is it the case that you can't contribute more than your regular income into pensions/SIPPs anyway, so all your contributions are assumed to come from your taxable income (ie day job)?
« Last Edit: February 14, 2019, 04:02:21 PM by vand »

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
A further q which I hope someone can help me with if I decide to explore the SIPP route.

Basically, as I understand the pension provider (in my case Fidelity) will automatically top up your SIPP by 20%, so if you pay in 800 you are topped up a further 200 under the assumption of applying basic rate tax relief.

My question is: what if the money you throw into the SIPP is earnt outside of your regular income (eg for the Rent-a-room which I suggested in my OP)? I would presume that you are not entitled to the top-up if you haven't paid any tax on it already. If I throw the 7500 from the rent-a-room into the SIPP, it would be wrong for them to top me up a further 20% on that, wouldn't it? How do you get around this? Do you need to declare it on a tax self assessment and pay it back to the Inland Revenue?

Or is it the case that you can't contribute more than your regular income into pensions/SIPPs anyway, so all your contributions are assumed to come from your taxable income (ie day job)?
Rent-a-room wouldn't count towards 'Relevant UK earnings:
https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#earnings
This income doesn't increase the maximum amount of tax relief you can get on SIPP contributions - which is limited to the higher of a)your relevant UK earnings for the tax year and b)the 40k annual allowance (plus any carry forward). What it may do though is increase the amount you can afford to contribute thereby getting you closer to the maximum.  HMRC treats all your money as fungible and will make no attempt to determine which bits of your cash came from rent and which from earnings, they just look at total contributions vs relevant earnings.

daverobev

  • Magnum Stache
  • ******
  • Posts: 3174
  • Location: UK
A further q which I hope someone can help me with if I decide to explore the SIPP route.

Basically, as I understand the pension provider (in my case Fidelity) will automatically top up your SIPP by 20%, so if you pay in 800 you are topped up a further 200 under the assumption of applying basic rate tax relief.

My question is: what if the money you throw into the SIPP is earnt outside of your regular income (eg for the Rent-a-room which I suggested in my OP)? I would presume that you are not entitled to the top-up if you haven't paid any tax on it already. If I throw the 7500 from the rent-a-room into the SIPP, it would be wrong for them to top me up a further 20% on that, wouldn't it? How do you get around this? Do you need to declare it on a tax self assessment and pay it back to the Inland Revenue?

Or is it the case that you can't contribute more than your regular income into pensions/SIPPs anyway, so all your contributions are assumed to come from your taxable income (ie day job)?
Rent-a-room wouldn't count towards 'Relevant UK earnings:
https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm044100#earnings
This income doesn't increase the maximum amount of tax relief you can get on SIPP contributions - which is limited to the higher of a)your relevant UK earnings for the tax year and b)the 40k annual allowance (plus any carry forward). What it may do though is increase the amount you can afford to contribute thereby getting you closer to the maximum.  HMRC treats all your money as fungible and will make no attempt to determine which bits of your cash came from rent and which from earnings, they just look at total contributions vs relevant earnings.

One side question - just say you were looking at a payslip, what counts as 'relevant earnings'? Is it the gross amount, before any deductions (except salary sacrifice, say)?

So if your slip said - numbers not real:

Gross: 3000
NI: 300
Tax: 200
Student Loan: 100

Can you put 3000 into the SIPP (allowance + carry forward allowing)?

vand

  • 5 O'Clock Shadow
  • *
  • Posts: 44
thank you PhilB, you are truly a doyen of retirement planning, and a bonafide wordsmith too boot... "fungible" is the word that helps explain all this! I would have just said "money is money" :D

This financial planning is turning into a minefield the more I delve into it, as I'm now weighing up the pros and cons of splitting my funds between my regular salary sacrifice pension, a SIPP, ISA, alongside keeping enough to finally pay off the mortgage and also eventually saving enough cash deposit together to finance a new home purchase in a couple of years' time. Am moving in the right direction but so much to think about and plan for!

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
One side question - just say you were looking at a payslip, what counts as 'relevant earnings'? Is it the gross amount, before any deductions (except salary sacrifice, say)?

So if your slip said - numbers not real:

Gross: 3000
NI: 300
Tax: 200
Student Loan: 100

Can you put 3000 into the SIPP (allowance + carry forward allowing)?
I've never come across the question as regards student loans before (yes, I'm old), but I'm pretty sure they are irrelevant for calculating the amount of pension contributions allowed - although not the other way round of course if you contribute to a pension from gross pay.  You could try posing the question on the MSE pension forum to get an expert answer.  As regards tax and NI then definitely ignore those so I'm pretty sure in the above example you pay 2,400 to the SIPP which gets grossed up to 3k.

PhilB

  • Pencil Stache
  • ****
  • Posts: 540
thank you PhilB, you are truly a doyen of retirement planning, and a bonafide wordsmith too boot... "fungible" is the word that helps explain all this! I would have just said "money is money" :D

This financial planning is turning into a minefield the more I delve into it, as I'm now weighing up the pros and cons of splitting my funds between my regular salary sacrifice pension, a SIPP, ISA, alongside keeping enough to finally pay off the mortgage and also eventually saving enough cash deposit together to finance a new home purchase in a couple of years' time. Am moving in the right direction but so much to think about and plan for!
It does all get horrendously complex pretty quickly.  I do wonder how the person on the Clapham omnibus is supposed to be able to understand it all.  I find it hard enough and I'm a lapsed chartered accountant.  It took me ages to learn all the wrinkles of the accumulation phase, now I'm having to work out all the nuances of decumulation with guessing when to time voluntary NICs to maximise SP, working out the best providers for drawdown and how much to leave with my DB at age 55 in the hope that it will allow me maximum TFLS when I take the DB at 63 (and pay any LTA charge owing).  First world problems!