There’s no question about it, pensions are officially the most tax-efficient way you can store your money in the UK. A whole range of incentives have been developed over the years to encourage workers to save for retirement and for their employers to assist them.
However, they can also be quite complicated. According to Jon Dean, head of retirement strategy at financial consultancy Altus, explaining taxation remains “one of the biggest challenges for pension firms when encouraging people to save for the long term”. Yet understanding them will help ensure your pension pot goes as far as it can.
Adding to the complexity, these benefits may shift slightly whenever a new government policy is announced. Currently, there is speculation over what might be unveiled in chancellor Rishi Sunak’s March 2021 Budget.
With the coronavirus pandemic and related recession pushing public borrowing to record levels, it’s likely the government will be looking to make savings wherever it can. So how might we see the way pensions are taxed change and what can we do to best prepare?
Generous tax relief
One of the most important pension tax benefits to understand is the tax relief offered on contributions up to £40,000 a year. For every £80 a basic-rate taxpayer in the UK, excluding Scotland, pays into their pension, the government tops it up to £100. This reduces to £60 for higher-rate taxpayers and £55 for additional-rate taxpayers.
“Less well understood is the fact you can still save up to £3,600 a year into a pension, or for children if you’re not working, and still benefit from the government’s 20 per cent uplift,” advises Dean. So in effect, this would only cost you £2,880.
There have been calls over the years for tax relief on higher earners to be reduced. According to Dean, additional-rate taxpayers make up only 11.7 per cent of the workforce yet represent half of all tax relief. There have even been suggestions that a single flat rate of tax relief should be introduced.
Dean describes this as “a political hot potato” that would particularly impact those with public sector pensions, which are tied to salaries, the very same people who have been shouldering society during the pandemic.
Neil Jones, tax and wealth specialist at Canada Life, says governments keen to make savings are more likely to lower the total size of the pot that can be kept tax free, rather than interfere with tax relief. This is the total amount you can have stashed away without any of the interest on it being taxed. It currently stands at £1,073,100, but has been higher in the past.
Withdrawing an income
Another major aspect of pension taxation is the tax-free lump sum. When you first dip into your pension pot, you can take 25 per cent out and use it as tax-free income. Previously, this was released when you took out an annuity – a type of insurance contract that gave you an income from your pension for life – until then-chancellor George Osborne introduced what’s known as “pension freedoms” in 2015.
These allow all savers to dip into their pensions from the age of 55 onwards and were designed to reflect the changing nature of retirement. The lump sum can, for example, supplement part-time work or be used to plug the gap between early retirement and the state pension kicking in.
However, the current economic climate may have forced some of us to dip into this just to make ends meet. HM Revenue & Customs figures for the fourth quarter of 2020 show there was a 10 per cent increase in flexible withdrawals from pensions compared to the same period in 2019.
Tom Selby, senior analyst at investment platform AJ Bell, warns that anyone wishing to use their pension in this way needs to be aware of the tax implications as once you withdraw more than 25 per cent, the amount of contributions you can enjoy tax relief on drops from £40,000 a year down to just £4,000. This means that topping your pot back up becomes increasingly difficult. “We are pushing the government to look at whether something can be done to make this fairer,” he says.
Dean adds that capping the tax-free lump sum could be an alternative money-saver for the government; a similar cap was recently introduced in Ireland. “However, the lump sum is the best understood part of UK pension rules,” he adds. “So this would just be adding further complexity.”
Passing your pension on
For those in the opposite situation, with a pension pot so large they won’t get through it all before they die, there are also benefits as the pot can be passed down to beneficiaries free of inheritance tax if death is before the age of 75. This means that, for those with enough assets, it’s better to work through ISAs and money gained from property before withdrawing your pension. Most experts don’t see this changing for the time being, but it would certainly be less politically risky than chopping other tax benefits.
One rumour currently doing the rounds is that the Budget could include changes to capital gains tax, with the percentage paid potentially being tied to an individual’s existing tax bracket. If this does materialise, Selby says it would create an even bigger incentive to invest as close to your annual £40,000 allowance in your pension as possible. “Moving your money into a self-invested personal pension and ISAs could become a better move than property investments,” he adds.
Overall, experts advise educating yourself on the benefits available and keeping track of any changes that may affect you remains the best way to prepare for a comfortable retirement. “The starting place for most people is always their workplace pension,” says Selby. If you can afford more than your £40,000 annual allowance, then seek independent financial advice on where the best place for your money is. “Trying to guess a chancellor’s next moves is always a tricky game,” Selby concludes.