As bonus payouts look set to shrink: How to make your annual bonus work as hard as possible

It’s that time of year when many firms announce annual bonuses for their staff, in particular those in the banking and financial services sectors. According to recent research, employees in positions that typically receive bonuses are gloomy on payouts this year, with 58 per cent expecting their 2024 bonus to be less generous or about the same as what they received last year.[1]

With the various pressures on household finances, it seems splashing out on big-ticket luxury items might be off the menu this year. Although investing a bonus into a pension is usually the most tax-efficient deployment of a payout, the survey suggests that higher mortgage rates, financial uncertainty and salary stagnation will see more bonus recipients pay down their debts.

Here Jason Hollands, Managing Director at wealth management and professional services group Evelyn Partners, looks at the most effective options open to bonus-recipients in this tax year:

“With a dearth of IPOs and M&A deals in 2023 and a swathe of redundancies in the City, it is unlikely to be a bumper year for payouts. Nevertheless, a lot of people will be due to get something, and wondering what to do with it,” Hollands says.

“While in the past many hard-working professionals have been tempted to splash the cash on a holiday or a new car, tougher times for the economy and much higher borrowing costs mean it may be wise to use any bonus payment to improve their financial position.

“The right course of action will depend on the person’s circumstances.”

Pay down mortgage or other debt

“For some, a high priority will be to pay off any lingering credit card bills as unsecured debts are generally the first port of call for financial security. For many others confronting the high interest rate environment, it will be paying down one or more of their mortgages.

“Although mortgage rates are thankfully coming down, anyone on a fixed rate deal taken out in recent years at ultra-low rates is still going to experience a sharp rise if their deal expires in the next couple of years. The impact of this on monthly payments will of course be lessened if the loan is paid down, particularly if it affords a cheaper deal by dropping into a lower loan-to-value band.

“For some families, with children in independent schools, it might be wise to use a bonus to reinforce a school fees plan, as Labour – who have a commanding lead in the opinion polls – have pledged to add VAT to school fees if they win the General Election later this year.” 
 
Tax mitigation

“As income tax thresholds are in the middle of a long-term freeze, which by the process of fiscal drag is increasing the tax burden on pretty much every wage-earner, mitigating exposure to tax on a bonus will be the key priority for many.

“Frozen thresholds mean the number of people being drawn deeper into the higher rate of tax Is rising rapidly, and a reduction in the threshold this year for paying the 45 per cent additional rate (from £150,000 to £125,140) is also drawing in hundreds of thousands more professionals with higher salaries.

“Many high earners will also be conscious that a bonus payment could take them up the steep marginal tax step at £100,000 of earnings. This is the point at which the tax-free personal allowance starts to be tapered away, resulting in a 60 per cent marginal tax rate on the band of income between £100,000 and £125,140 - as well as the loss of Government childcare entitlement.” 
 
Pension contributions

“The most straightforward tax-efficiency move - effectively awarding yourself an income tax cut - is to use some or all of your bonus to make a pension contribution, as these provide income tax relief at your marginal rate.

“This means someone who is a 40 per cent taxpayer can make a gross pension contribution of £10,000, for a net cost of £6,000, once the tax relief is factored in. It really is compelling and there is no guarantee that the current system of pension tax reliefs will remain untouched in the future. 
 
“If your bonus award has not yet been granted, but is coming up shortly, you should speak to your employer as soon as possible to see if they will facilitate ‘salary sacrifice’.

“This is where instead of receiving a bonus, you opt to forgo it (or some of it) in lieu of a company pension contribution instead. The reason why this is particularly attractive, is that not only will the earner save on income tax, but also on National Insurance – as will the employer, with many adding their saving to the employee’s.

“If you have already received your bonus or it has already communicated to you, you can still use it to subscribe for a pension by making a personal contribution, but you won’t be able to claim back the National Insurance deducted. If you are subject to the higher or additional rates of income tax, it is vital that you complete a self-assessment tax return and disclose your personal pension contributions on it, to ensure you get the tax relief that you are eligible for.

“A caveat with pension investing is that while the tax reliefs are highly attractive, there are restrictions on when you can start to access your pension. This is currently age 55 but due to rise to age 57.”

Tax-efficient investments

“Another way to use your bonus to cut your income tax bill is to subscribe to a Venture Capital Trust new share issue. VCTs are specialist investment companies that invest in small, earlier-stage UK growth companies which are either unquoted or issuing shares on the AIM market. They are therefore higher risk investments, but to incentivise people to back such businesses, the Government does provide a cocktail of tax perks.

“When you invest in a VCT new share issue, you can claim a 30% income tax credit off the sum invested (via your tax return), meaning a £10,000 subscription will enable you to lop £3,000 off your income tax bill for the year the shares were allotted to you. And once you’ve invested, any dividends or gains from the VCT shares are tax free. However, it is important to hold the VCT shares for a minimum of five years – selling them earlier, will require you to repay the tax credit. Up to £200k can be invested in VCT share issues this tax year, netting a maximum tax credit of £60k.

“VCT share offers come and go, with the most popular ones typically filling up and reaching their fund-raising targets well ahead of the tax year end. You can see which ones are still open, and how much capacity left they have on the Bestinvest website here: https://www.bestinvest.co.uk/vcts/current-launches

“For those who neither want to tie their bonus up in a pension, nor a risky VCT, utilising an ISA should be high on their radar.

“While ISAs won’t enable you to recoup the tax you’ve paid on your bonus, they will protect future returns from taxation. That’s incredibly important given the rising tax burden and the Chancellor’s plans to keep squeezing investors harder in April. From 6 April, the annual capital gains exemption is set to be halved again (from £6,000 currently to £3,000) and the amount of dividend income that can be received tax-free is due to be slashed to a mere £500 a year.

“However, when you save or invest in an ISA, all returns are free from tax, whether capital gains, dividends or interest on cash, and you don’t even need to disclose them on your tax return. While pensions may have the edge when it comes to tax relief, ISAs win hands down for flexibility as you can make withdrawals at any time and are not locked in.”

NOTES

[1] Financial Times annual bonus report:  
https://www.ft.com/content/466e8a11-f523-4f70-b299-6496a1aac77b