Tax advantages of saving into a pension

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 Please Note: Information in this blog was current at the time of publishing, but may no longer be up-to-date with current legislation. Please visit our blog for the latest pension articles.

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There are various options for saving for retirement, and many people like to have ISAs or investments alongside their pension while others may choose to have an alternative retirement plan entirely, such as buy-to-let properties. It goes without saying that having multiple savings funds is a sensible tactic (although it's important to be aware of the pros and cons of each to ensure you make the best decision for your circumstances), but there are some Income Tax advantages that make pensions very rewarding.

Perhaps the main advantage is that tax relief is applied to pension contributions. There are a number of criteria that apply to qualify for tax relief, including being a UK resident, and it's important to seek professional advice so you know your specific situation. If you are a basic rate taxpayer contributing £8,000 a year into your pension fund, that amount would have been £10,000 before £2,000 was deducted for Income Tax. By putting that money into a pension, though, HMRC will add the £2,000 back to it, immediately increasing your pension contribution to £10,000. At the age of 55, you can remove 25% as a tax-free lump sum, which in this case would be £2,500. The holder then has a pension of £7,500 at a cost of £5,500.

As your tax rate increases, so does the benefit of tax relief. Income Tax relief on pension contributions comes in two forms: PTRAS (Pensions Tax Relief at Source – this is the 20% relief for basic rate Income Tax) and the refund of any further relief directly to you if you are a higher or additional rate Income Tax payer. This refund can take the form of either a tax refund or a reduction in tax due.

Let's use an example of a 45% taxpayer contributing £80,000 to a pension fund, which is bumped up to £100,000 with the automatic 20% tax-relief:

  • £80,000 paid into pension fund (subject to eligibility*)
  • Basic rate tax relief will be £20,000, taking fund to £100,000
  • Remove £25,000 as tax-free cash, reducing the fund to £75,000. This means you have only paid £55,000
  • Receive £25,000 tax relief, reducing total contributions to £30,000, and fund is still £75,000

Using the above method, a person will have bought a £75,000 pension fund for £30,000.

There's also the consideration that once you earn over £100,000 you begin to lose your Personal Allowance, which, in the 2014/15 tax year for people born after 5/4/1948, is £10,000 you can earn before you pay tax. Once you earn over £100,000 the allowance is lost at a rate of 2-to-1: earn £105,000 and you lose £2,500 from your allowance, earn £110,000 and you lose £5,000, and if you earn £120,000 you lose all of it. This actually works out as an effective tax rate of 60% on earnings between £100,000 and £120,000. The following tables compare the tax due for a person earning £100,000 and a person earning £115,000                                                                                                           

Income subject to income tax

£100,000  

Personal allowance

£10,000  

Subject to basic tax rate (20%)

£31,865 £6,373
Subject to basic tax rate (40%) £58,135 £23,254
Total tax due £29,627

 

Income subject to income tax

£115,000  

Personal allowance

£2,500  

Subject to basic tax rate (20%)

£31,865 £6,373
Subject to basic tax rate (40%) £58,135 £23,254
Total tax due £38,627

 

The difference on the tax owed is £9,000, which is 60% of £15,000, not the 40% you might expect!

In some cases, however, paying into a pension can restore the lost allowance. For example, if you earn £120,000 and put £10,000 into a pension, your allowance will be £5,000 again; pay £20,000 and you will have the full £10,000 tax-free Personal Allowance again.

What do you think of the pensions tax benefits? Let us know on Twitter or Facebook.

Call 0800 304 7288 for a friendly chat about your pension

Important Information

Based on a £50,000 sum at onset, growing at 6% per year before charges of 0.5% and 1.5% are applied.

The details provided in this article are for general information only and are in no way deemed to be financial advice. All of the material is correct as of the publication date, but could be out-of-date by the time you read the article. For our latest information and news, please see our articles section: https://www.portafina.co.uk/whats-new

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