It’s vital to save for retirement, and it makes sense to save in the most tax-efficient way to make the most of your hard-earned cash, but it’s also important to live life to the full.
SoGlos speaks to Cheltenham's RBC Brewin Dolphin about striking the right balance between valuing experiences today versus saving for tomorrow.
About the expert - George Taylor, financial planner at RBC Brewin Dolphin
George Taylor joined RBC Brewin Dolphin's Cheltenham office in 2018. He advises private clients on their financial planning needs, specialising in pensions, tax-advantaged investments, protection, estate planning and cash flow modelling.
He holds chartered financial analyst and chartered financial planner qualifications and maximises his clients’ finances by making the most of tax allowances and reliefs.
Can you explain how tax relief works on pension contributions?
For most, pensions represent the most tax-efficient form of saving and investing. This is due to the quadruple whammy of:
- Tax relief on pension contributions (at your marginal rate of income tax)
- Tax-free investment income and gains within the pension
- The ability to draw a proportion of funds tax-free once you reach minimum pension age — this is usually 25 per cent of the pension value, up to a maximum £268,275
- The funds typically sit outside your estate, in which case, any residual pension savings can be passed down to your beneficiaries, completely free of inheritance tax
How much can you contribute?
Essentially, there are three limits — two upper bounds and one lower one. Each tax year, you can contribute up to the lower of:
A whopping 100 per cent of your UK ‘relevant earnings’ — this is typically work-related income, whether that be from an employed or self-employed role. It excludes investment income and most rental profits (the exception is profits from qualifying furnished holiday lettings).
Or the annual allowance, including any ‘carry forward’ (such as unused allowances) from the previous three tax years.
The standard annual allowance is £60,000 per year; however, this is tapered at a rate of £1 for every £2 that ‘adjusted net income’ (generally, total taxable income plus all pension contributions, including employer) exceeds £260,000, down to a minimum of £10,000.
For those who have already accessed their pension savings ‘flexibly’ (for example, taking some drawdown income), a flat limit of £10,000 per year applies.
This is subject to a minimum of £3,600 gross per year, up to age 75; this is applicable for those with relevant earnings below the threshold, most commonly, a retiree or homemaker.
Could you share a case study on tax relief in practice?
Let's say Jimmy has income of £75,270 and is therefore a higher-rate taxpayer. He’s sitting on surplus cash of £50,000 and wants to invest this in a tax-efficient manner.
A good option here would be to make a gross pension contribution equivalent to the excess of income above the higher-rate tax threshold of £50,270, i.e. £25,000. This would fully qualify for higher-rate tax relief (40 per cent). He could contribute more, but any contribution over and above this amount will only qualify for basic-rate relief (20 per cent) – a better option would be to repeat the contribution in the following tax year, so that he once again hits 40 per cent relief.
In terms of how this would work in practice, Jimmy could make a net contribution of £20,000 to a personal pension (this is the amount he would actually pay in). The pension provider would reclaim basic-rate tax relief on his behalf, crediting the plan with £5,000. As a higher-rate taxpayer, Jimmy would subsequently reclaim a further £5,000, most commonly by completing a self-assessment tax return.
As such, once all tax relief is granted, the actual net cost of a £25,000 gross pension contribution is ‘just’ £15,000. That’s equivalent to a 67 per cent effective return on tax relief alone.
The alternative would be to boost contributions to a workplace scheme via salary sacrifice. This comes with the added benefit of employee National Insurance (NI) savings. Some employers will also recycle their employer NI savings via an additional top-up. But this is very much scheme and employer dependent.
What about pension contributions in retirement?
Many people don’t realise you can continue to contribute to a pension post-retirement. Consider the following example.
Ben and Heather are 60-years-old and have both recently retired. Whilst they have no ‘relevant earnings’ for pension contribution, they can nevertheless continue to contribute £3,600 gross to each of their pensions and will receive tax relief up to the age of 75.
Whilst this might sound small fry, for many people it’s still well worth doing. In practice, they will make a net contribution of £2,880 each. As in the previous case study, their pension providers will then credit their plans with £720 (basic rate relief).
Moreover, for those with an inheritance tax planning objective, a pension contribution has the effect of immediately transferring assets outside the estate for inheritance tax purposes.
In the example above, assuming Ben and Heather ‘max out’ their pension contributions each year (combined £5,760 net / £7,200 gross), this will increase the amount to be inherited by their beneficiaries by £3,744 per year. This is equivalent to the 40 per cent inheritance tax saving on the net contribution amount (40 per cent x £5,760 = £2,304) plus the full proceeds of the basic-rate tax relief (2x £720 = £1,440).
Repeat this to age 75, and add in some compound investment growth for good measure, and the potential uplift in inheritance is substantial.
Furthermore, the monies will remain available to Ben and Heather should their circumstances change, such as an increase in costs that may arise such as care.
Can you explain how marginal 60 per cent tax relief works?
In certain instances, individuals can benefit from an effective 60 per cent income tax relief. Again, this is best explained via an example.
Joe has taxable income of £120,000 a year and is therefore a higher-rate taxpayer.
However, he incurs an effective 60 per cent tax on earnings between £100,000 and £120,000 due to the tapering of his tax-free personal allowance, which is reduced by £1 for every £2 that income exceeds £100,000. In Joe’s case, it is tapered from the maximum £12,570 to £2,570. This is known as the ‘marginal 60 per cent tax trap’.
But the personal allowance taper is based on so-called ‘adjusted net income’, which deducts any personal pension contributions (and also charitable donations that are eligible for Gift Aid). In other words, you can reclaim some/all this tax-free allowance via pension contributions.
In this instance, Joe makes an ad-hoc gross pension contribution of exactly £20,000 (the excess of taxable income above the £100,000 threshold for the personal allowance taper).
In practice, he will make a net contribution of £16,000. The pension provider will automatically reclaim basic-rate tax relief on his behalf, crediting the plan with £4,000. As a higher-rate taxpayer, he will later reclaim a further £4,000 upon completion of his tax return, plus another £4,000 as his personal allowance shall be fully reinstated. This brings an extra £10,000 of income under the tax-free threshold (whereas this would otherwise be taxed at 40 per cent).
In other words, the actual net cost of a £20,000 gross pension contribution is just £8,000, an effective 150 per cent return on tax relief alone which is as good as it gets from a tax-efficiency standpoint.
What are the drawbacks of pension contributions?
The tax benefits of pension saving are compelling. But when considering whether to commence or increase pension contributions, it’s important to weigh this up against the drawbacks of pension contribution, the most important one of which is access, or lack thereof.
Generally speaking, private pension savings can only be accessed once you reach minimum pension age. This is currently set at 55, but is due to increase to 57 in April 2028, to coincide with the rise in the state pension age to 67. A further increase to 58 is likely (such that the minimum pension age sits ten years below the state pension age).
There’s therefore a trade-off — tax efficiency versus access.
And whilst it’s important to be saving for retirement, and saving in the most tax-efficient way, it’s also important to live life to the fullest and therefore strike the right balance between experiences today versus saving for tomorrow.
The value of investments, and any income from them, can fall and you may get back less than you invested. This does not constitute tax or legal advice. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Opinions expressed in this publication are not necessarily the views held throughout RBC Brewin Dolphin Ltd. Forecasts are not a reliable indicator of future performance.