Since the changes to pension legislation were announced earlier this year there have been a lot of column inches given over to the virtues of investing in a pension, In particular, those subject to higher rate tax whilst they are working have an opportunity to capitalise, especially if they are likely to drop back into the basic rate tax bracket once they reach retirement.
The table at the bottom of the page illustrates exactly this point.
It assumes a higher rate tax payer makes a gross pension contribution of £10,000 per annum for 10 years which, after higher rate tax relief, results in a total net cost of £60,000. Based on an investment return of 5% per annum the pension has grown to £132,068 compared to the £60,000 invested into an ISA (without the benefits of tax relief) that has grown to £79,241.
After taking 25% of the pension fund tax free and the balance subject to basic rate tax (this would need to be done over several years to avoid any higher rate tax liability) the net amount available out of that accumulated fund is £112,258. A gain over the initial £60,000 net cost of £52,258. That equates to a return of 11.14% per annum compared to 5% on the ISA.
|Investment Return||£10,000 gross p.a. for 10 years||Pension fund||Pension return||ISA||ISA return|
|5%||Accumulated fund||£132,068|| ||£79,241|| |
|Net lump sum||£112,258|| ||£79,241|| |
|Increase on net cost||£52,258||11.14%||£19,241||5%|
Despite this obvious benefit there is still a misconception that savers will not reap the benefits until they retire. The reality is that there are a variety of valuable tax planning benefits that can further enhance the tax relief on contributions.
For those individuals with ‘net adjusted income’ above £100,000 their personal income tax allowance will reduce by £1 for every £2 of income in excess of that amount. This effectively means that once your income exceeds £120,000 your entire £10,000 tax free allowance is lost. However you are allowed to deduct personal contributions to a pension in calculating your net adjusted income.
Someone with income of £110,000 who makes a contribution of £10,000 will effectively get 60% tax relief on it – normal higher rate tax relief of £4,000 plus the £2,000 due from reclaiming their personal allowance.
The same principle applies for those investors with Children earning between £50,000 and £60,000. The recent changes brought in to remove child benefits for these parents can be countered by making a pension contribution to reduce that net adjusted figure back under £50,000. When you add higher rate tax relief to the reclaimed child benefit it’s an effective rate of tax relief of 64.7%.
Pension contributions can also be used to mitigate other forms of tax. For individuals that who have table income and taxable gains exceeding the basic rate band the rate of capital gains tax is 28%. For those below this threshold it is 18% and where any gain pushes part of the income and gains over the band there will be proportionate liabilities.
Paying a pension contribution can bring you back into the basic rate income tax and consequently 18% CGT bracket.