Relief as pension tax stays untouched
The Chancellor’s decision to defer any major changes to pension tax relief is a sensible one, with automatic enrolment at its peak and the pension freedoms still bedding in.
The fact that the Government has conducted such an open debate on incentives to save has been useful though. Not least, it has reinforced how important it is to make the most of the current pension tax system.
With retirement savings very much in the forefront, now could be a great time to be reminded of the benefits of pension saving.
The combination of tax relief on contributions coupled with the new pension freedoms makes pensions a very attractive place to save for retirement. Pensions are now far more accessible than ever before, allowing greater opportunity to provide a legacy from any funds which are not spent during retirement. And this should increase their appeal to savers as long standing barriers to pension savings, such as limited access and loss of fund on death, have been removed.
Pension tax relief received on contributions
For Defined Contribution (DC) or Final Salary schemes, savers will pay in an amount net of basic rate tax, with the provider adding basic rate tax to the fund (higher or additional rate relief claimed through self-assessment).
Some employees in occupational pension schemes will have their contributions deducted directly from their salary before tax. This gives them immediate tax relief at their highest rate without the need to make any reclaim via self-assessment, with all their tax relief going directly into their pension.
In either scenario, the net cost to an investor paying higher rate tax is £6,000 for a £10,000 pension contribution.
Income tax payable on withdrawals
Up to 25% of the pension fund can be taken completely tax free. The balance will be taxed as income.
That means the £10,000 contribution in the example above, ignoring growth and charges etc, would provide £2,500 tax free cash and £7,500 of taxable income. If taxed at 40% in retirement that would be £7,000 in the pocket (£2,500 tax free cash and £4,500 net income) for a net cost of £6,000.
But in reality higher rate taxpayers don’t pay 40% tax on their income. In fact the most any higher rate taxpayer (on incomes up to £100,000) with a full personal allowance will ever pay is 29% – and that’s ignoring tax free cash.
This is because we have an income tax system which works in bands, so we don’t pay a fixed rate of tax on all our income.
For example, we might refer to someone earning £50,000 as a 40% or higher rate taxpayer. But they will only pay 40% higher rate tax on the top £7,000 of their income. When you factor in their personal allowance and the tax they pay at basic rate, the effective rate of tax on all their income is 18.4% – less than half the 40% headline rate.
So for a net cost of £30,000, a higher rate taxpayer would get £50,000 in to their pension. But on taking their benefits, after deducting tax free cash, personal allowance etc (and ignoring growth or charges), it would provide £44,700 of spendable income – a 49% uplift on their spend. This assumes they have no other income which has used already up their personal allowance etc.
And most savers* who pay higher rate tax during their working life don’t continue to do so in retirement. According to the Centre for Policy Studies less than 1 in 7 higher rate taxpayers will remain subject to higher rate tax once they stop working. And this means the effective rate a basic rate taxpayer will pay on their retirement income will be between zero and 15%.
For many savers it may be just as important to also consider what can be passed on to family members on death. Pensions are typically IHT free, unlike most other savings vehicles which will be included in the estate.
Plus the new inherited drawdown rules mean funds can be retained within the pension wrapper, allowing the next generation to continue taking an income whenever they need it. And a beneficiary will receive this income tax free if the original pension scheme member died before age 75.
Pension funds pay no UK tax on income or capital gains which accrue within the fund. This is exactly the same exempt treatment which savers enjoy within an ISA. But with pension funds being boosted at outset with the addition of tax relief, it means savers are enjoying tax free investment returns on an increased fund.
The immediate pressure to maximise contributions ahead of the Budget has now eased. But while the spotlight is most definitely on pension saving, now is a great time to be reminded of exactly how valuable the benefits are under the current regime.
Source: Standard Life