Pensions and tax relief: Keep hold of more of your money!

March 24, 2015

Tax doesn’t have to be taxing. So said the advert a few years back.

And yet, despite those claims, tax is still seen as a complex issue by many, and navigating it with skill seems to be exclusively reserved for rock stars, large corporations and banks with offshore accounts. For the little guy or gal, confusion still reigns, especially where pensions are concerned.

But, there are titbits of knowledge that can at least provide you with some signposts. If you don’t understand the intricacies, at least you can get your head around some of the broader concepts.

This is a good point to say that everyone’s tax situation and plans for the future are unique. Good tax planning can save you money in the long run, so where tax is concerned, it’s probably worth getting some advice. In the meantime, here’s a quick look at some of the tax implications of putting money into, and taking money out of your pension.

Tax relief when you pay into your pension

Pensions have always been seen as a way to save tax efficiently. One of the main reasons is because of the tax relief you receive when you pay into them.

We’ve covered the numbers before, but here’s a quick recap. If you pay into a pension yourself, or if your employer takes your pension contribution from your monthly pay packet, you automatically get 20% tax back from the Government. So, if you put £80 into a pension, £100 actually goes in.

If you’re a higher rate tax payer, you can claim an additional 20% on some or all of the contribution (if covered by sufficient income in that band, e.g. to get 40% tax relief on a £10,000 gross contribution would need at least £10,000 of income in the higher rate band). And if you’re a top-rate taxpayer that goes up to 25%.

Compare this to an investment ISA, and it’s easy to see why a pension is an attractive way of saving for the future. Put £60 in to an ISA, and, well, £60 goes in. Put £60 into a pension as a top-rate taxpayer and £100 goes in (if covered by sufficient income in that band), enabling your money to grow faster and compound more effectively.

It’s one of those ideas that sounds too good to be true, and remarkably, it isn’t. It works exactly the way it seems to.

However, these rules are the ones that currently apply. Who’s to say that this tax relief will still be around in 10 years’ time? With a General Election looming, tax relief is an area of hot debate, with all sides talking about changes. Some proposals may only affect the very wealthy in the UK, while others may affect everyone. If the idea of tax relief sounds interesting, then now is the best time to take some action.

Each year, only a certain amount of money can be given tax relief and put into a pension, and each year, that allowance disappears if you don’t use it. Or maybe not, because if you’re kicking yourself for missing out on this tax relief, then there’s one more little nugget of information that might come as a welcome relief – it’s possible to carry forward unused allowances from the previous three years and add it to this year’s allowance. Of course, it depends on your personal circumstances, such as how much you’ve already paid into a pension, and how much you’ve earned, but the concept is there.

So, it’s clear that there are tax advantages to paying money into a pension plan, which leads us nicely onto…

Tax relief when you start drawing from your pension

The tax relief that you get when you pay into your pension is only one part of the story. The next chapter is the benefit you get when you take it out, and that comes in the form of a 25% tax free lump sum.

Yes, that’s right. We said ‘tax free’! Build up a £400,000 pension pot, and you could take £100,000 out of it without paying a penny in tax as soon as you’re eligible.

In fact, this is an area which is worth looking at a little deeper, as withdrawing money will become even more flexible in April 2015. Essentially, you’ve got three main options (although each has their nuances). The first is to take your entire pot as cash. On the face of it, that sounds great. But, after you’ve used up your tax free 25%, any money remaining will be charged Income Tax at your highest marginal rate for the tax year in which you take it. So, if you do decide to buy the now infamous Lamborghini, then you’ll likely be paying tax at 40%, or maybe even 45%. So, while it’s an option, it would leave a significant dent in your pot.

The second option is to make use of the tax free 25% and then use the rest of your pot to provide some kind of income. This could be in the form of an annuity or through Income Drawdown.

You may find the third option even more attractive. In short, you take smaller cash withdrawals over a number of years, which could prevent you going into a higher rate tax bracket in any given year. This route gives you the option of taking 25% of each payment tax free, rather than take a 25% cash lump sum at the beginning. This can be achieved either by adopting a phased drawdown strategy or by something called Uncrystallised Funds Pension Lump Sum (UFPLS).

No matter the route you choose, the fact that you can take 25% of your pension pot tax free remains one of the stand-out features of a pension, and marks it out as one of the most tax efficient ways you can save.

What could change?

In short, a lot. Tax relief on the money going in could change, especially as that tax relief is currently worth £34.8bn a year. Compare that to the annual military spend of around £33n and you can see why all sides of the political table will have an eye on reducing that burden.

And perhaps at some stage the Government will decide that the 25% tax free lump sum is a bit too generous. Perhaps they’ll scrap it altogether, or we’ll see an Income Tax rise to compensate for that tax relief. You don’t have to go back too far in our history to find Income Tax rates significantly higher than they are today. In fact, in 1967-68, a special charge was imposed, meaning that for investment income over £8,000, the rate was 45%. With income tax at 41.25% and a surtax at 50%, the total rate was 136.25%!

Maybe we’ll see people make a shift towards ISAs, where all of the tax is already paid and the money is 100% yours. It would be easy to see why they would suddenly become more attractive.

So there you have it – a brief look at the tax benefits of a pension. It’s not everything you need to know, and you’ll have a lot more research to do before you make any decisions, but now you have an understanding of why pensions are good from a tax point of view.

 

This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.

GreenSky Wealth Limited is authorised and regulated by the Financial Conduct Authority. FCA No. 629624. Registered Office as above. Registered in England and Wales, Company No. 07103441. The Financial Conduct Authority does not regulate Tax Advice.