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Danby Bloch: Tax relief on pension contributions – what’s it really worth?

Unless you move from a higher to basic-rate tax band when you retire, you will only get 6.25 per cent relief 

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The value of pensions tax relief for a basic-rate taxpayer is a miserable 6.25 per cent of the net investment – if you take account of the tax charge payable on the benefit. 

But if you are a higher-rate taxpayer when you make pension contributions and a basic-rate taxpayer when you take the benefit, the value of the relief is a far more attractive 44.66 per cent.

So the key to the tax efficiency of a pension investment is not the simple story of tax relief on the input. What matters is the difference between the tax relief on the input and the tax charge on the benefit. This has been clear for a long time but the capacity to take all the benefits as a lump sum makes the situation clearer still. The other advantage of pension investment is the fund is more or less free of tax but that is a privilege it shares with Nisas and offshore bonds, where the rules on access are much less restrictive. So there is a case for looking at the tax relief on input and tax charge on benefits in isolation to see what they are worth overall.

Table help

A new table from LV= helps to identify the winners (and losers) quickly and easily. 

Each cell represents a calculation of the difference as follows. First take the basic-rate taxpayer. Their gross input is £10,000 but the net cost after 20 per cent relief is £8,000. 

At maturity, a quarter of the £10,000 is tax-free and the rest is taxed at 20 per cent; the net return after tax is therefore £2,500 + £7,500 x 80 per cent = £8,500. The profit – purely from the tax relief less the tax on benefits – is therefore £500 or 6.25 per cent of the net input of £8,000.

On the chart, locate the rate of tax relief on the input of 20 per cent, then run your finger along the tax rate on benefits to 20 per cent and see them meeting at 6.25 per cent. That is a total return of 6.25 per cent – not an annual return. The overall tax advantage in this case comes only from the tax-free pension commencement lump sum.

Contrast that with someone who gets 40 per cent tax relief on their contributions but pays only 20 per cent tax on their pension benefits – a common situation. The value of the difference between the tax relief on the input and the tax charge on the benefit is 41.66 per cent.

Salary sacrifice will add some very valuable National Insurance contribution relief to the differential but self-employed people cannot benefit from this NIC arbitrage.

The effective 60 per cent tax relief on contributions is available to relatively few people whose income falls between £100,000 and £120,000 on which there is an effective 60 per cent marginal tax rate. 

If they can make pension contributions in this tax band, the value of the difference between net tax differential subsidy is a massive 150 per cent if they improbably end up as nil taxpayers or a very attractive 112.5 per cent if they are 20 per cent taxpayers in retirement.

There are clients for whom pension investment does not look attractive and for whom Nisas would be better, such as the individual who is a basic-rate taxpayer when contributing and a higher-rate taxpayer in retirement – they suffer a net tax loss of -12.5 per cent. That is a possible trajectory for someone who is a relatively low earner in their early career and who becomes very successful later. 

  • You can draw several conclusions from this fascinating matrix:
  • This subsidy to the relatively well-off may not last forever so clients should take advantage of it now.
  • Some clients would be better off in Nisas than pensions. Is it really worth a lifetime basic-rate taxpayer tying up their money in a pension rather than a Nisa, or even an equity collective outside and a Nisa, just to get a 6.25 per cent boost?
  • The NIC relief from salary sacrifice could make all the difference to the numbers for some clients.
  • The tax-free lump sum is really important, especially for less well-off clients.

The net impact of tax relief and tax charge on pension 

  Tax charge on benefits

Tax relief
on input

0%

20%

40%

45%

60%

20%

+ 25%

+ 6.25%

– 12.5%

– 17.19%

– 31.25%

40%

+ 66%

+ 41.66%

+ 16.67%

+ 10.42%

– 8.33%

45%

+ 81.8%

+ 75%

+27.27%

+ 20.45%

0%

60%

+ 150%

+ 112.5%

+ 75%

+65.62%

+ 37.50%

Source: LV=

Pensions flexibility – the new rules

Keep your clients up to date with a personalised guide to the new rules and proposals announced in the Budget affecting retirement income. The latest edition to our Key Guides series covers:

  • Revisions that took effect from 27 March
  • Total drawdown flexibility that should be available from April 2015
  • New Class 3A NICs
  • Likely increases to the minimum pension age
  • Reductions on death benefits for some individuals.

To find out more, call Alex Broughton on 020 7970 4196

Danby Bloch is editorial director at Taxbriefs

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