What is pension tax relief?
Pension tax relief is a boost by the government on pension contributions. All contributions within the annual allowance – even those made on behalf of children – receive relief at 20%, which is the basic rate of income tax. Higher and additional rate taxpayers receive 40% or 45% relief, respectively.
Pension tax relief can have a huge impact on the size of a fund, especially when compound interest is factored in. It is applied to contributions and no tax is applied to growth, making pensions particularly effective savings vehicles. In comparison, money added to a regular savings account is already taxed, and tax applies to growth from interest. As the government defers receiving income tax when money is added to a pension, it instead applies it on withdrawals, although up to 25% can usually be released as tax-free cash.
How does pension tax relief work?
When you make a contribution, the government automatically adds the 20% that is usually deducted from earnings. However, it does not only apply to people in work – it’s also added to contributions made by people out of work or to children’s pensions. The following examples show the difference tax relief can make:
- If you add £80 to a savings account or ISA, it will be worth £80
- If you add £80 to a pension, the fund will be worth £100
Although income tax is applied on most pension withdrawals, it is applied at the person’s marginal rate at the time they take it – which means a person could have received 40% or 45% tax relief and pay only 20% income tax on the withdrawals. The advantage of more money being in the fund from the beginning is that compound interest is applied to larger sums, helping to create a bigger retirement fund. The example below, from The Telegraph, highlights the power of compound interest and uses an assumption of 6% growth throughout:
- If you save £100 a month from age 25 to 65, you could have a fund of around £190,000
- If you save £200 a month from age 45 to 65, you could have saved the same amount of money but the fund will only be worth around £90,000
This example highlights how effective auto-enrolment could be, particularly for younger people. Not only will their funds receive generous contributions, but they will be growing for a long time and have a great opportunity to reach a good size.
Other savings accounts aren’t as generous
When money is held in regular savings and current accounts, income tax can be charged on the interest, which lowers the overall gains. ISAs are somewhere between regular accounts and pensions, as taxed income is added but no tax is applied on the growth. ISAs also allow money to be held in stocks and shares, which isn’t possible in current or savings accounts.
There could be more changes to pensions
In the Emergency Budget, the chancellor announced that the government had published a green paper to discuss the possibility of radical changes to simplify the tax system for pensions, with one possibility being to make them similar to ISAs by removing the relief on contributions and having tax-free growth and withdrawals. One of the main effects of this would be a removal of the minimum age limit currently applied, which could make them a more appealing option for young people.
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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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