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If you are saving for the future, it's nice to get a little help from the taxman. The Government offers some really great tax breaks when saving via pensions, but this is often misunderstood, so let’s have a closer look.
There are three stages at which the taxman gets involved in pensions. The first is before the money is invested – in other words, when it is earned. The second is while the money is within the plan, and the third is when the funds are withdrawn from it.
So if, for example, you put a certain proportion of your net salary into a pension, you can effectively reclaim tax that you have already paid, via tax relief and whilst your money is held in a pension any investment gains are exempt from tax.
At the final stage, when you come to take your money out of the scheme, it is a reverse of the position at the first stage (although your tax position could be different in retirement). So, money taken out of a pension is subject to Income Tax. Higher-rate taxpayers can expect to gain more from the tax relief on their pension contributions than they are likely to lose when they come to pay tax on their pension income in retirement. This is because far fewer people are higher-rate taxpayers after they retire.
Pensions have a unique additional tax break- the ability to release a quarter of the pension fund as a tax-free lump sum when you reach the age of 55. This slice of your money is completely tax-free – a perk that, legally at least, only a pension can offer.
Here is an example of how this all works:
If you invested say, £10,000 to help fund your retirement and we assume that the investment fund you choose to hold inside the pension doubled in value between now and when you take the benefits, the amount that actually gets invested depends on the rate of tax you pay. If a 20% taxpayer puts £10,000 into a pension, £2,000 is automatically added back to the investment by the pension plan provider (they reclaim tax relief from HMRC). If, as we’ve already assumed, investments double, the final pension pot would be worth £24,000 so you could take 25% of this amount, or £6,000 as a tax-free lump sum, leaving £18,000 from which to secure retirement income
Things are different for a higher-rate taxpayer. If £10,000 is invested, the value of the pension is still £12,000 (with the addition of basic-rate tax relief which is added automatically), but being a Higher Rate tax payer, additional tax relief is available and this is claimed via your tax return. So a 40% tax payer could claim back up to an additional 20% and additional rate tax payers potentially more.
In both examples any income you take from this residual pension pot is taxable, so the final amount you end up with after tax depends on your circumstances, but hopefully this quick run through shows how compelling the tax benefits of saving via a pension are, particular for those who pay tax at higher rates.
There are also tax advantages for business owners, as pension contributions by employers are generally regarded as deductible business expenses, so this can have a positive effect on Corporation Tax by reducing taxable profits.
Successive governments keep tinkering with the rules surrounding pensions, so it makes sense to consider planning now and making the most of the opportunities available.
Nathan Glaister, Financial Planning Consultant.
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Armstrong Watson Financial Planning Limited is authorised and regulated by the Financial Conduct Authority. Firm reference number 542122. Registered as a limited company in England and Wales No. 7208672. Armstrong Watson Financial Planning & Wealth Management is a trading name of Armstrong Watson Financial Planning Limited. Registered Office: 15 Victoria Place, Carlisle, CA1 1EW