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Pensions are often a highly effective means of investing for retirement owing to the tax relief on contributions.
“Free money? Are you sure?!”
That was the reaction to my explaining pension tax relief recently. It wasn't exactly a sparkling conversation, but I think my friend's mind was sufficiently blown for him to act. "I'm going to take a look at that", he concluded.
It’s sad, though, that so many aren't aware of pension tax relief, the substantial boost to the payments you make into your pension. Almost everyone includes a comfortable retirement as one of their financial goals so countless people are missing out.
It can have a considerable impact on the size of your retirement funds and the income you’re paid. What’s more, it doesn’t matter if you’re not earning or paying tax. If you are a UK resident and under 75, you can still receive some tax relief on pension contributions.
How pension tax relief works
Currently, anyone under 75 with relevant UK earnings can receive tax relief when they make a contribution within the annual allowance to a personal pension such as our SIPP. HMRC adds 20% and any further higher or additional rate income tax relief can be reclaimed – potentially a simple way of reducing your income tax bill for the year.
For example, an investor contributes £8,000 into their SIPP and £2,000 is claimed back from HMRC by the pension provider. A higher rate taxpayer could claim back up to a further 20% via their tax return, reducing the overall cost of the contribution to as little as £6,000. In the same instance, additional rate taxpayers could claim back up to a further 25% making the cost just £5,500 for a £10,000 contribution.
That’s a huge boost to your money right away, and an uplift that would otherwise only come with lots of risk or plenty of time in the market.
How much can you contribute?
The generosity of tax relief does, however, come with limits. Contributions that attract relief are restricted to 100% of your relevant UK earnings – essentially earned income rather than any other form of income such as dividends or interest. Contributions, including those paid by your employer, are also subject to an ‘annual allowance’, which is usually £40,000.
Higher earners get a lower annual allowance, which could limit their maximum contribution to as little as £4,000 a year. The rules on when this ‘tapered annual allowance’ kicks in are complicated, but HMRC has more information on how to calculate it here. For people who receive ‘flexible’ retirement benefits, such as a flexi-access pension (e.g. pension drawdown or taking more than 25% cash from their pension), a lower annual allowance of £4,000 applies.
If you haven’t used your full annual allowance from up to three previous years, you might be able to carry it forward and use it in the current tax year provided your earnings are high enough and you have been a member of a registered pension scheme in those preceding years. People earning more than £40,000 who wish to maximise pension contributions may be able to take advantage of this. Additional guidance and examples can be found on the government’s money helper website.
Remember, the tax treatment of pensions depends on individual circumstances and is subject to change in future.
Non-taxpayers can benefit too
It is also possible for non-taxpayers to benefit from pension tax relief. In the 2022/23 tax year, individuals under age 75 can contribute up to £2,880 to a pension and receive a further £720, resulting in an overall contribution of £3,600. In addition to upfront tax relief, money in a pension is free from capital gains tax and any income tax.
The lifetime allowance
It is also important to be aware of the cap on the total value of your pensions from which you can draw benefits without triggering a tax charge (known as the “lifetime allowance”). This is currently frozen at £1,073,100. Defined benefit (‘final salary’) pension benefits are also tested against this limit based on the amount of income they provide when they come into payment.
Is a pension better than an ISA?
For those who need access to their money before retirement (the minimum for pensions being 55 currently and rising to 57), an ISA offers greater flexibility. At present, pension benefits cannot be accessed until this time, and this minimum age is set to rise in the future. For those choosing a savings vehicle for retirement, the decision is a trickier one. Many investments are available in both ISAs and pensions.
Assuming that investments grow at the same rate in both a pension and a conventional ISA account, in the majority of cases the benefit of upfront tax relief at a person’s highest income tax rate means investing in a pension works out mathematically better. This reflects the fact that pension tax relief on the way in makes an important contribution to overall return. The fact that you can generally take 25% as a tax-free lump sum before drawing the pension also helps.
The main exception to this is for a basic rate taxpayer funding a pension and then becoming a higher rate taxpayer when taking benefits – a situation that could arise if an entire fund is taken in a lump sum, either on purpose or accidentally through poor tax planning. In this scenario, an ISA would produce a better overall return. However, given that it is possible to take periodic income or variable lump sums from pension pots there is scope to plan how to withdraw money tax efficiently.
A further option for younger investors, a Lifetime ISA, can form up to £4,000 of the £20,000 ISA allowance for those eligible. Available to UK residents aged between 18 and 40 saving for retirement or a house deposit, it is possible to pay in up to £4,000 each tax year and continue making contributions up to the age of 50. The government will add a 25% bonus to contributions – a maximum of £1,000 each year – and withdrawals are penalty-free from age 60 or if used for an eligible house purchase.
Take advantage of pension tax relief while it lasts
As it stands today, a pension remains the financially more appealing retirement investment vehicle for most people, including those remaining in the same tax band, or who drop down a tax band or two, once they draw their pension.
However, no one can be sure of pension rules in the future. Tax relief may become less generous, especially for higher earners. For instance, a flat-rate incentive of between 25% and 33% for all pension contributions has been suggested. It may make sense for some people to secure pension tax relief in its current form while it lasts.
To discuss any of the themes raised in this article, or to find out how Charles Stanley could help you create a more secure financial future, contact a member of our Plymouth team.
Call us on 01752 545 969, email plymouthbranch@charles-stanley.co.uk or visit www.charles-stanley.co.uk/help-and-contact/people-locations/plymouth
The value of investments, and any income derived from them, can fall as well as rise. Investors may get back less than originally invested. The information in this article is based on our understanding of UK Legislation, Taxation and HMRC guidance, all of which are subject to change. The tax treatment of pensions depends on individual circumstances and is subject to change in future. This article is solely for information purposes and does not constitute advice or a personal recommendation. Charles Stanley & Co. Limited is authorised and regulated by the Financial Conduct Authority.