Of all the tools you can use when planning your retirement, the pension is undoubtedly the one to keep your savings plan fully charged
Recent changes to the rules governing pensions mean that generous tax relief is now combined with flexible access to your money when you eventually draw on your pension funds – an unbeatable combination.
However, successive governments have already reduced the amounts investors can contribute tax efficiently to pensions on an annual and lifetime basis, and there is constant speculation there will be further cuts to pensions tax relief in an attempt to balance the Treasury’s books.
Pensions contributions benefit from tax relief at an investor’s marginal rate – potentially worth up to 45% in England, Wales and Northern Ireland and up to 46% in Scotland. Your investment grows free of tax, and you can take 25% of the eventual fund as tax-free cash.
Pensions can also provide a very attractive solution for those trying to reduce the inheritance tax bill on their estate, says Michael Angus, Wealth Planning Director and Chartered Financial Planner for Sanlam in Edinburgh. “An investor can nominate a particular person to get the money from their pension pot after they die, and depending on their age at death, the money can be tax-free,” he says.
You can also use a process called ‘carry forward’ to increase your pension contributions. “Carry forward allows unused annual allowance from the three previous tax years to be used in the current year,” says Angus. “This means that if you have not contributed to a pension at all in the three previous tax years, and you have sufficient earnings, you may be able to boost your pension fund by up to £160,000.”
Much of that money would be contributed by the government, so a higher-rate tax payer on a marginal rate of 40% could add £96,000 to their pot and receive £64,000 from the Treasury. These figures would be even more attractive with Scottish tax rates.
However, every year there is speculation that the Chancellor of the Exchequer will cut pension tax relief. Before last October’s Budget, for example, it was rumoured that Philip Hammond would reduce higher-rate pension tax relief to help generate £20 billion in additional funding promised to the NHS.
It would take a brave government to do something as radical as scrapping or even reducing the very popular tax-free lump sum, or introducing a flat-rate tax relief system for contributions.
But Angus says that previous governments have already reduced the amount of tax relief available to investors through a less obvious route – by cutting the amount they can invest.
The annual allowance, which is the amount you can save into a pension each year for which you can claim tax relief, has fallen from £255,000 in 2010/11 to £40,000. This limit is tapered for those who earn more than £150,000 a year, reducing to a maximum of £10,000 for those earning £210,000 or more.
The lifetime allowance – the amount that you can withdraw from your pension schemes through lump sums and retirement income without triggering an extra tax charge – has also been reduced, from £1.8 million in the 2011/12 tax year to just £1.055 million. If you exceed this limit you could incur tax charges of 55% or 25%, depending on how you take the money. As a result, the amount of tax collected because of breaches of this allowance has risen by 2,000% in a decade.
Some investors, including members of the NHS pension scheme, pay contributions based on their salary band and do not have the flexibility to reduce the amount they contribute. According to the British Medical Association, increasing numbers of doctors are breaching pension savings limits and are facing hefty tax bills. The Financial Times reported in January that this issue is contributing to some GPs deciding to take early retirement.
However, there are ways to avoid having to pay additional tax, says Angus. These include different ‘protection’ schemes offered from 2006 onwards, when the allowance was first introduced. Earlier schemes are no longer available for new applicants, but Angus says: “Those investors who did apply for these protections at the time should review them regularly with the help of their financial adviser to make sure they are still suitable for their purposes.”
Two forms of protection are still available – fixed protection 2016 and individual protection 2016. You can find out more about the protection available on the government website,* but the process is complicated and it is best to seek professional financial advice.
In addition to applying for protection, Angus says investors could consider investing in alternative tax-efficient investments, or, if they belong to an occupational scheme, stopping their own pension contributions or talking to HR about taking benefits in a different form. Those who opt out of further pension investment and who are employed should beware being auto-enrolled into their employer’s pension scheme – it could cost them dearly, warns Angus.
Given the current political and economic uncertainty surrounding Brexit, it is quite likely that there will be speculation about further cuts to pension tax relief and allowances during this year.
Angus says: “It is impossible to predict what the government will do next when it comes to pensions. But investors should not let this deter them from using an incredibly flexible and tax-efficient way of saving.
“The best way to deal with uncertainty about the future is to make the most of the allowances and tax reliefs that are available right now. Talk to your financial adviser about how to maximise – and protect – your pension contributions and look forward to reaping the benefits when you retire.”
Here are a few of the numbers that show the true cost of pension tax relief and how the government has already begun to limit this generous tax break.
£43.7 billion the expected cost of pension tax relief for 2018/19 according to HMRC
£34.6 billion the cost of pension tax relief in 2014/15
“Eye-wateringly expensive” Chancellor Philip Hammond’s description of pension tax relief
£561 million the tax collected for annual allowance breaches in 2016/17 (the year that the tapered annual allowance was introduced for higher earners), compared with £179 million in 2015/16
£102 million the tax collected for lifetime allowance breaches in 2016/17, compared with less than £5 million in 2006/7