Tax relief and your pension

 

Image: stux, Pixabay

Image: stux, Pixabay

I mentioned last week that one of the benefits of pensions is that they are tax efficient, with tax relief on your contributions, the fund growing tax-free, and the ability to take 25% as a lump sum tax-free when you retire. However, in the upcoming budget on 16 March it is expected that the government will announce changes to the tax relief on pension contributions, alongside other potential changes to the taxation of pensions. I’ll take a quick look here at the current rules applying to pensions and what might change.

What exactly is tax relief?

The term ‘tax relief’ refers to any scheme that allows someone to not pay tax on part of their income. There are two main ways in which tax relief is given: either you pay less tax because you deduct certain expenses from your total income before paying tax on the balance (as happens with contributions into a company pension scheme); or the government pays tax back to you or repays it in another way (as happens with contributions into a personal pension).

If you pay into a company pension scheme, your employer will deduct your pension contributions from your gross salary and tax relief at your highest rate of tax is applied automatically. If you pay into a personal pension, your contribution is net of tax and the pension provider will claim back 20% tax relief for you from the government (you will need to claim back extra through your tax return if you’re a higher rate tax payer). Though the method in which tax relief is applied is different dependent on which type of pension you have, the end result with both methods is that any money you save into a pension is free of tax. It means if you’re a basic rate tax payer that for every £100 going into your pension pot, it’s actually only costing you £80. If you’re a higher rate tax payer, for every £100 going into your pension pot, it’s only costing you £60.

There’s an overview of tax relief on pensions on the government’s website, and also various tax relief calculators such as that offered by Hargreaves Lansdown where you can enter your salary and the amount you would like to contribute to a pension, and it works out how much tax relief you will get.

Possible move to a flat-rate tax relief

The current system of tax relief on pension contributions favours those with higher income, and one of the measures the government might introduce on 16 March is a flat-rate system of tax relief. If this happens, possibly with immediate effect, the rate is expected to be set between 25% and 33%. It will mean basic rate tax payers will be better off, but higher rate tax payers will be worse off. The BBC has a good article showing the impact on each, along with other rumoured pension changes.

Other potential changes

Tax relief on contributions is capped at the value of your annual earnings, and is subject to both an annual allowance and lifetime allowance. The annual allowance has been reducing and currently means you get tax relief on contributions up to £40,000 a year (less if you earn over £150,000), and it’s rumoured this might reduce to £25,000 a year this April. The lifetime allowance is the amount the government will allow you to have tax-free in your pension pot. It is currently £1.25 million, and will reduce in April to £1 million. At present, I don’t think either of these changes will impact me, but higher earners paying large sums into their pension will be affected, as will those nearing retirement trying to make up for under-funding their pension in earlier years.

Other possible changes include scrapping tax relief on contributions completely, which would remove the up-front tax benefit of saving into pensions, and make them more like ISAs. They would still grow tax free, and when you draw your pension it would be completely tax free (not just 25% tax free as now). If the government is looking to encourage saving for retirement, then removing one of the incentives of saving into a pension doesn’t seem to me to be that sensible – I’d rather receive my tax benefit now than trust that the government will deliver on its tax promise when I retire.

With the budget in a couple of weeks we’ll know what the changes will be, which might help with decisions about whether to place extra savings into a pension or into other types of investments.

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