It’s that time of year again… The end of the tax year. So don’t forget to have a look at your unused investment and savings tax allowances as in most cases if you miss them they are gone for good. I know I have rambled on about pensions in many previous articles but with pension freedoms giving much more post-retirement flexibility, pensions are really now super tax-efficient savings accounts (albeit it without access until you are 55) and the tax reliefs and concessions make them very compelling.
Why so compelling? Let’s look at the maths. If you pay your pension contribution personally your contribution is paid net of basic rate tax. So a £1000 cheque means your invested sum is £1250 if you are a basic rate taxpayer. The full £1250 is invested (a huge range of investment options are available) and investment returns accrue tax-free on the full gross amount. If you are a higher rate taxpayer you enter your contribution on your tax return which effectively reduces your gross income by £1250, and you therefore will not pay higher rate tax on £1250, saving you £250 further tax. So your net contribution is only £750 but you have £1250 in your pension fund. An effective ‘overnight’ return of 66.66%!
If you have worked hard enough to earn over £100,000 you are being punitively taxed as every extra £2 of earnings means you lose £1 of your tax-free allowance, so if you earn £123,700 you have no free tax allowance, an effective tax rate on the £23,000 of 60%! By paying a pension contribution of £23,700 (a cheque for £18,960), your income is reduced back to £100,000 and you get the free tax allowance back PLUS the 20% higher rate relief. A further tax saving of £7,110!
Remember that 25% of your pension can be paid tax-free after the age of 55 (rising to 57 in 2028) and your pension fund is also usually exempt from Inheritance Tax.
There are limits on what you can pay in each year, but pensions are unusual in that in many cases you can go back three previous tax years and use missed allowances. This is very important if, as is widely expected, a future budget (this year?) reduces the tax relief available for higher rate taxpayers.
Don’t Forget! If you run your own business then your company can pay your pension contributions for you and any contributions get corporation tax relief with no personal tax or national insurance as long as the contribution falls within the allowed limits.
I always consider pensions ahead of ISAs due to the relief available on the contribution and the IHT aspect. If you have ISAs but lack the funds to pay into your pension then why not use your ISA money and grab those reliefs whilst they are available? If you have maxed out on your pensions or you are too young to want to lose access to the money until you are 55 then don’t forget the ISA allowance is a huge £20,000 a year. Paying into ISAs each year can build up a significant fund, and as with pensions, there are many investment types available within them. Why put into a cash ISA for long term savings when the interest rate is less than inflation? Even a moderately speculative portfolio held within an ISA should give a real return above inflation over the medium to long term.
As well as Pensions and ISAs there are plans available for more sophisticated or less risk-averse investors such as Enterprise Investment Schemes and Venture Capital Trusts that offer similar tax reliefs to pensions, but are for the shorter term and generally riskier.
Footnote; Investments can go down as well as up. This article is for information only and does not constitute advice.