Putting Off Pension Saving: Benefits & Drawbacks
MAKING pension contributions is possibly the simplest yet most effective bit of year-end tax planning you can do. For every £1 you invest you typically get up to 40p back from the taxman, effectively eliminating a big chunk of your income tax bill.
Financial experts usually advise people to start making pension contributions as early as possible. They usually point to the ‘magic’ of compounding. Compound interest seems to possess magical powers, making millionaires out of just about anyone who starts early enough.
However, people often confuse saving in a pension with saving generally. It’s never too early to start saving… but there are reasons why you might not feel like putting money into a pension right now.
Firstly, basic-rate taxpayers (generally those earning less than £42,475) only enjoy 20% tax relief on their pension contributions. So the question is, should they postpone making pension contributions until they become higher-rate taxpayers and can enjoy 40% tax relief?
Even if you are a higher-rate taxpayer, you may not feel like saving in a pension right now because your money will be tied up until age 55 and access thereafter is still restricted. The question is, will you be worse off as a result?
Before answering these questions let’s take a brief look at some of the rules. To obtain tax relief on your pension contributions they have to stay within certain limits:
- Earnings. Contributions made by you personally must not exceed your annual earnings (generally your salary or pre-tax business profits, but not dividends, interest or most rental profits). If you don’t have any earnings you can still contribute up to £3,600 per year.
- The £50,000 Annual Allowance. Total pension contributions by you and anyone else (normally an employer) must not exceed £50,000 per year.
The above limits are for gross pension contributions (typically NOT the amount you invest personally). Gross contributions include 20% basic-rate tax relief (normally credited to your pension plan by HMRC). Your gross contributions are found by dividing your actual cash contributions by 0.80.
Should you delay making pension contributions if you are currently a basic-rate taxpayer but expect to become a higher-rate taxpayer in the future?
Many self-employed business owners who are normally higher-rate taxpayers may be basic-rate taxpayers from time to time, for example if their income falls during tough economic conditions or if they have abnormally high tax deductible expenditure for the year.
Many company directors are also basic-rate taxpayers in some years but higher-rate taxpayers in other years, for example if they vary their dividend pay-outs.
Case Study 1
Penny and Isabella are self-employed. Both are basic-rate taxpayers this year but expect to be higher-rate taxpayers in three years’ time. Both want to save £3,000 per year. Penny decides to put her savings in a personal pension. Isabella decides to put her money in an ISA until she is a higher-rate taxpayer. Then she will transfer the money into a pension.
Who ends up better off?
We’ll assume both enjoy investment returns of 7% per year (tax free inside both an ISA and pension). Penny’s £3,000 annual investments are topped up with £750 of free cash from the taxman (basic-rate tax relief). After three years she will have £12,900.
Isabella’s £3,000 annual ISA investment will be worth £10,320 after three years. Right now, clearly, she is lagging behind Penny the pension investor.
At the start of the fourth tax year Isabella takes her £10,320 ISA savings and sticks them into her pension plan. The taxman will add £2,580 in basic-rate tax relief and, hey presto, she has £12,900 sitting in her pension, just like Penny.
However, now that she’s a higher-rate taxpayer, Isabella will also receive an extra 20% higher-rate tax relief when she submits her tax return. Penny didn’t get this additional cash injection because her contributions were made while she was a basic-rate taxpayer. To calculate Isabella’s higher-rate tax relief we simply multiply her gross pension contribution by 20%:
£12,900 x 20% = £2,580
In summary, Penny and Isabella have both saved exactly the same amount of money. Isabella waited until she became a higher-rate taxpayer before making pension contributions. She ends up with £2,580 (20%) more money than Penny.
Note, although Isabella postpones her pension contributions, she does NOT postpone saving. Note too that she invests in an ISA so that she does not miss out on tax-free growth.
Many people are put off making pension contributions because of the lengthy jail sentence placed on their savings: no access until age 55 and limited access thereafter. It’s a fat lot of good having £100,000 in your pension pot if your home’s about to be repossessed!
But what about all the tax savings enjoyed by pension savers? If you delay, won’t you lose out?
Case Study 2
Peter and Ian are both business owners and higher-rate taxpayers but they have completely different retirement planning strategies.
Peter saves £4,000 per year in a pension. The taxman adds £1,000 of basic-rate tax relief, bringing his total pension saving to £5,000. He also receives £1,000 of higher-rate tax relief, so the net cost of his investment is just £3,000.
Ian also saves £3,000 but, because he is worried about tying up his money in a pension, puts his savings in an ISA.
Let’s assume they increase their contributions by 3% per year to compensate for inflation and both enjoy tax-free growth of 7% per year.
After 10 years Peter will have £83,358 sitting in his pension pot. Ian, on the other hand, will have just £50,015. (Remember they both invested identical amounts of money and enjoyed identical investment returns.)
Let’s say Ian is now more confident about his financial future and doesn’t mind sticking his ISA savings (or an equivalent amount) in a pension.
In fact, because he knows he’ll get a tax refund (his higher-rate tax relief) he can actually make a slightly bigger investment of £66,686 (calculated by dividing his £50,015 ISA savings by 0.75).
The taxman adds £16,672 of basic-rate tax relief and, hey presto, Ian ends up with £83,358 sitting in his pension pot – exactly the same as Peter!
Ian also gets a tax refund of £16,672 (£83,358 x 20%), so his personal investment is just £50,015 – exactly the amount he accumulated in ISAs.
In summary, Peter started saving into a pension from day 1, whereas Ian put his savings into an ISA, before transferring the money into a pension 10 years later. By postponing his pension contributions, Ian was able to access his savings in the event of a financial emergency. Postponing his contributions has not left him out of pocket by one penny.
Postponing Pension Contributions – Other Issues
There are dangers and practical issues when it comes to postponing pension contributions:
Danger # 1 Higher Rate Tax Relief Could Be Scrapped
You cannot trust politicians not to meddle with the pension system. One proposal that has been bandied about is scrapping higher-rate tax relief on pension contributions. If Ian only receives basic-rate tax relief when he makes his catch-up contribution in 10 years’ time, he will end up with just £62,519 (£50,015/0.8) – over £20,000 less than Peter.
Danger # 2 Loss of Employer Pension Contributions
If you belong to a workplace pension scheme and your employer is matching the contributions you make personally, postponing could prove costly: you will be losing a lot of free cash.
Danger # 3 Your Earnings Fall
If your income has fallen and you are no longer a higher-rate taxpayer when the time comes to make catch-up contributions, you will not enjoy higher-rate tax relief.
Practical Issue # 1 Higher Rate Tax Relief
To catch up with Peter, Ian has to make a gross pension contribution of £83,358. To enjoy full higher-rate tax relief he must have at least this much income taxed at 40%, which is unlikely (see accompanying box). There is fortunately a solution – Ian could spread his catch-up contributions over several tax years.
Practical Issue # 2 Exceeding the Annual Allowance
Big catch-up contributions are more likely to exceed the £50,000 annual allowance. It is possible to carry forward unused annual allowance from the three previous tax years, so a gross pension contribution of up to £200,000 is allowed (providing you have sufficient relevant UK earnings and belonged to a pension scheme in each of those years). Again the best practical solution for Ian would probably be to spread his contributions over several tax years.
Practical Issue # 3 Tax Free Growth
An important reason why Ian was able to catch up with Peter was because Ian also enjoyed tax-free investment growth by putting his money in an ISA. If Ian’s savings had been taxed, he would have ended up permanently worse off.
In summary, it is possible to put off pension saving if you don’t want to tie up your money right now… but there are some dangers and practical obstacles.
Maximising Higher-Rate Tax Relief
Many higher-rate taxpayers (generally those earning over £42,475) don’t enjoy the maximum 40% tax relief on their pension contributions because they don’t understand how higher-rate relief is calculated. It’s a bit like paying for a business class ticket and accidentally sitting in economy.
The maximum higher-rate tax relief you can claim is:
Your Gross Pension Contribution x 20%
You will only enjoy the maximum higher-rate tax relief IF you have at least this much income taxed at 40%. If your income is £42,475 plus £1, you will only enjoy higher-rate tax relief on £1 of pension contributions.
To maximise your tax relief you should make sure your gross pension contributions do not exceed the amount of income you have taxed at 40%.
Instead of making any lump sum pension contributions, you may want to consider spreading your pension contributions over a number of tax years.
Sandy is a sole trader with pre-tax profits of £50,000. He has £7,525 of income taxed at 40% (£50,000 - £42,475). Sandy puts £15,000 into a pension. The taxman adds £3,750 of basic-rate relief. His gross contribution is therefore £18,750 (£15,000/0.8).
However, Sandy doesn’t have £18,750 of income taxed at 40%, he only has £7,525. So his actual higher-rate relief is:
£7,525 x 20% = £1,505
Essentially he is losing out on £2,245 of higher-rate tax relief because he doesn’t have enough income taxed at 40%:
£18,750 - £7,525 x 20% = £2,245
What can Sandy do? He should consider spreading his pension contributions over several tax years.
If you are a higher-rate taxpayer and maximising tax relief is your priority, the maximum you should contribute to a pension in the 2011/12 tax year is:
Your taxable income minus £42,475This is your maximum gross pension contribution. Multiply this number by 0.8 to obtain the maximum amount you can actually invest (your net cash contribution).