Richard Curtis highlights tax benefits and some considerations for pension contributions.
Retirement often seems a long way away and there are commonly more pressing financial needs; eating and heating to name but two topical ones. However, starting to save early is likely to result in a larger eventual pension ‘pot’.
Today, most pensions are what are known as ‘defined contribution’ schemes. In these plans, the pension fund value depends on the amounts paid into it and subsequent investment growth. By contrast, in older style ‘defined benefit’ schemes (still available to some employees), the eventual pension payable is determined by final salary and length of service. These are increasingly rare.
Tax relief on contributions
As well as the gains from making an early start to pension saving, remember that contributions made by employees and the self-employed attract tax relief at their highest rate of tax. Generally, tax relief at the basic rate is given by deduction from the premium payable.
For example, a pension premium payment of £80 a month represents £100 from which basic rate tax relief of 20% has been deducted. The pension scheme will recover the £20 from HM Revenue and Customs, so the pension fund receives a total of £100. If the taxpayer is liable to tax at 40%, they can claim a further £20 tax relief on their tax return. This means that £100 is invested in the pension at a net cost of £60.
Restrictions
Subject to an upper age limit of 75, tax relief on annual pension contributions is limited to the higher of:
- the individual’s UK taxable earnings for the year; and
- £3,600.
Contributions exceeding £40,000 are subject to tax at the individual’s marginal rate of tax, so any tax relief given will be recovered.
Note also that this £40,000 limit is subject to the following restrictions:
1) If the individual is already drawing a pension (other than the state pension) the limit is reduced to the ‘money purchase allowance’ of £4,000.
2) The £40,000 annual allowance is reduced if the individual’s ‘adjusted income’ (i.e., broadly income including pension contributions) for the tax year is more than the adjusted income limit. The rules are rather complicated, but if the adjusted income limit (currently £240,000) is exceeded, the allowance is reduced by £2 for every £1 of excess income down to a minimum level of £4,000. This would happen when adjusted income is £312,000.
3) Rather more complicated, an ‘alternative annual allowance’ may apply to individuals who have accessed a defined contribution pension or a qualifying overseas pension that has received UK tax relief.
The lifetime allowance
Finally, a lifetime allowance (currently £1,073,100) applies to an individual’s total pension savings. The limit is checked whenever a ‘benefit crystallisation event’ occurs. The main such events are when the individual becomes entitled to receive a pension (or a pension increases by more than a defined amount) and when they reach the age of 75 with undrawn pensions.
If the value of the pensions at those events exceeds the lifetime allowance, the excess is charged at 55% if paid as a lump sum benefit, or at 25% otherwise. So far, this charge has affected relatively few people (e.g., 8,510 in 2019/20), but the numbers are likely to increase. The rules are complex, and individuals who believe they may have funds approaching the limit should take specialist advice.
Tax relief in the fund
Once money has been paid into the pension scheme, the administrators will, generally, invest this to achieve growth. Pension funds are exempt from capital gains tax on gains made by these investments.
Further tax relief and rules apply when funds are withdrawn from a pension; but that is a subject for another article.
Practical tip
The 40% higher rate tax threshold remains unchanged. If earnings rise, more people will pay tax at the higher rate, so pension contributions will become more tax effective. Financial advice should be taken.
