Almost everyone includes a comfortable retirement as one of their financial goals. Pensions are often a highly effective means of achieving this due to the tax relief available on payments into them. When you contribute to your pension, the government adds money. This is called tax relief and is one of the main advantages of using a pension to save for retirement.
Not everyone is aware of this special helping hand offered to pensions, but it can have a considerable impact on the size of your retirement funds and the income you are 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’ll still receive some tax relief on pension contributions.
As we approach the end of the tax year, it's worth looking at whether you could benefit from making a pension contribution.
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 the Charles Stanley Direct SIPP. 20% is added by HMRC 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.
How much can you contribute?
Tax relief on your personal contributions is limited to 100% of your relevant UK earnings. Contributions, including those paid by your employer, are also subject to the annual allowance, which for the 2019/20 tax year is usually £40,000. However, those with ‘adjusted’ income over £150,000 for this tax year have a reduced annual pension allowance, the minimum being £10,000. There’s information on how to calculate this 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 in the 2019/20 tax year who wish to maximise pension contributions may be able to take advantage of this. There’s guidance and examples on the government’s pension advisory service website here.
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 2019/20 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 £1.055million and is to rise with inflation. 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 age 55, 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. 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 tax-free from age 60.
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 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.
The Taxation of pensions is based on individual circumstances and may be subject to change in the future.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.