The tax benefits of pensions
Will we see a reduction in the tax reliefs given to pensions announced in Thursday’s Autumn Statement? Rishi Sunak and Jeremy Hunt are understood to be considering a number of tax rises and spending cuts, with the Resolution Foundation think tank warning that £40bn of savings are needed to meet the government’s fiscal targets.
The pair warned of decisions on spending of ‘eye-watering difficulty’ in the aftermath of COVID and Liz Truss’s disastrous mini-budget.
One area that is almost certain to be under consideration is the generous tax reliefs given to pensions. Every year the government gives billions back to investors as tax relief on their pension contributions. UK residents under 75 can even get tax relief if they don’t pay tax.
In view of this I thought it would be helpful to remind us all of the current tax reliefs given to pensions so that we can better understand any changes that are announced on Thursday.
The tax benefits of pensions
- Income tax relief is provided on eligible pension contributions at your highest marginal rate, currently 20%, 40% or 45%. In the current tax year once you earn over £50,270 you will pay higher rate tax. So if, for example, your gross income was £55,000, but making an additional pension contribution of £3,784 (i.e. £4,730 gross) you would remove yourself from paying any tax at more than 20%.
- When funds are withdrawn from your pension, either by means of an annuity or pension drawdown, 25% can usually be paid free of tax with the rest subject to income tax. This tax-free cash element gives your pension a significant advantage over saving in an ISA, for example. Although pension benefits taken above the 25% tax free portion are taxable, there are many couples where one partner will only receive a State pension in retirement. If a personal pension fund is contributed to over the years for the lower income partner much, or all, of the benefits taken in retirement may be completely tax free because, together with the State pension, they are below the personal allowance, currently £12,570 pa.
- While funds are invested in your pension they grow in a very tax efficient environment. There is no tax on dividend income, or interest income and no income tax or capital gains tax arising on the funds or any liability for you while they remain invested.
- Tax relief on pension contributions is limited by the annual allowance with the standard allowance being currently £40,000 a year, although this can be as low as £4,000 for very high earners or those who have already flexibly accessed their pension benefits. Having said that, if you have not made full use of the annual allowance in the previous three tax years and contribute the full annual allowance in the current tax year you can ‘carry forward’ that unused tax allowance and obtain tax relief on pension contributions of more than £40,000 in the current tax year.
- As well as the annual allowance, tax relief on personal contributions is restricted to the level of your relevant UK earnings (or £3,600 if higher) in the tax year they are paid. So as long as you are under age 75 you can still obtain £720 tax relief on a pension contribution of £2,880 even if you are not paying tax in the current year.
- Pension benefits can usually be paid out free of inheritance tax where the scheme has discretion over who should receive them. In addition, all benefits are payable free of income tax if you are unfortunate enough to die under the age of 75. Where you are aged 75 or above when you die, the benefits are taxed at the beneficiary’s marginal rates of income tax as and when they draw them.
- The pension funds can remain outside of anyone’s estate if held in a beneficiaries’ drawdown and passed down the generations while remaining in a tax efficient environment.
- Your employer might offer you the option of ‘salary sacrifice’ as part of their pension scheme. This is a way to make your pension saving even more tax-efficient. As you are effectively earning a lower salary, both you and your employer pay lower National Insurance contributions (NICs), which often means your take-home pay will be higher. Better still, your employer might pay part or all their NIC saving into your pension too (although they don’t have to do this).
Pension contributions can reduce tax in other ways
Whilst I have listed the main tax benefits of pensions there are other ways in which pensions can produce a tax saving in the right circumstances.
- Capital gains tax on investment gains is charged at 10% or 20% (18% or 28% on second homes). The rate of capital gains tax is determined by adding the gain to your other taxable income as a ‘top slice’. Therefore, if you can reduce your other taxable income by making an additional pension contribution you may be able to reduce the rate of tax on your capital gain.
- Where your income is above £100,000 your personal allowance is gradually reduced by £1 for every £2 of annual income over £100,000. Therefore once your annual income is over £125,000 you will have no personal allowance. As a consequence the marginal rate of tax for your income that falls between £100,000 and £125,000 is actually 60% (tax at 40% higher rate plus tax at 20% on the loss of personal allowance). By making an additional pension contribution you will reduce your income, possibly below £100,000, and it will save you a lot of tax.
- The high income child benefit tax charge (HICBC) impacts you if you have adjusted net income over £50,000 and are (or your partner is) receiving child benefit. Reducing adjusted net income by making an additional pension contribution can reduce the impact of HICBC or remove it entirely.
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