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What is the best way to invest for retirement?

Income tax relief is available on pension contributions. This can be a significant advantage.

| 6 min read

Whether you are new to investing or nearing retirement, pensions are likely to be an important consideration. When you make a contribution 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.

Could you benefit from making a pension contribution?

In the 2020/21 and 2021/22 tax years, an investor can receive up to 45% tax relief when they make a contribution to a personal pension such as a SIPP (Self Invested Personal Pension), with 20% paid by the government into the pension and any higher and additional rate income tax reclaimable.

For example, an investor contributes £8,000 into their SIPP and £2,000 is claimed back from HMRC by the pension provider meaning £10,000 is invested overall. 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.

In addition to upfront tax relief, money in a pension is free from capital gains or income tax on the investments. Remember that SIPPs are not investments in their own right, they represent a wrapper within which you can hold a range of assets, so it’s up to you where you want to invest the money – including your tax relief!

Contribution limits

The basic rule is that you can invest up to £40,000 into your pensions each year (including any tax relief), or a sum equal to your annual income if lower. However, 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 are potentially an issue for those earning more than £200,000.

There’s also a lower annual allowance for people that have started to access their pensions flexibly post-retirement age, for example by taking an income through drawdown. Lower earners and those with no income at all get a minimum annual allowance of £3,600.

Remember, the tax treatment of pensions depends on individual circumstances and is subject to change in future.

Taking money out of a pension

The disadvantage of a pension is that you must wait until retirement age to take money out – though you could view this as a good thing as you can’t be tempted into taking it out early! At present, the minimum age is 55 but it is set to rise in the future.

When you take money out of a personal pension it is taxable as income, but you can take 25% of the value tax free under current rules.

Is a pension better than an ISA?

For those who need access to their money before age 55, an ISA, which has an annual limit of £20,000 and the facility of tax-free withdrawals at any time, offers greater flexibility. For those choosing a savings vehicle for retirement, the decision is a trickier one. Most investments are available in both ISAs and pensions.

Assuming investments grow at the same rate in both a pension and an ISA account, in most cases the benefit of upfront tax relief at a person’s highest income tax rate means investing in a pension works out 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 a quarter as a tax-free lump sum 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 accidentally 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 to minimise tax.

It is also worth noting that a further option, a Lifetime ISA, offers a modest ‘hybrid’ option. There is a 25% ‘bonus’ on contributions, broadly equivalent to basic rate tax relief, and no tax when money is taken out to buy a first home or for retirement after age 60. However, the maximum amount you can contribute each year is much lower at £4,000, which also counts towards the overall £20,000 annual ISA allowance.

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 25% or 33% for all pension contributions has been suggested, so it may make sense for some people to secure pension tax relief in its current form while it lasts.

What sort of retirement can you afford?

Visit our Options at Retirement Hub, to learn more, or to arrange a free initial consultation with a dedicated planner to discuss how you can make the most of your retirement savings.


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.

What is the best way to invest for retirement?

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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.

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