Mark Devlin, Senior Technical Manager at Prudential looks at how pensions tax relief works to help with planning for clients.
Winning the lottery has its appeal, who wouldn’t like turning the cost of the ticket into a fortune? Pensions tax relief in essence gives you free money (albeit with a lesser return than a lottery win). To keep the gambling analogy going, if there was a fruit machine that would pay you out net of tax 85 pence for every 80 pence that you put in (assuming that only basic rate taxpayers are spinning the fruits) who wouldn’t keep playing the machine until the coins run dry?
The main difference with pensions tax relief over gambling is that this money is given risk free. The only risk after receiving the tax relief is where you invest the money.
Please note, any reference to gambling should be caveated that you should only gamble responsibly with money you can afford to lose, and of course when the fun stops, stop! Pensions tax relief, however, is something that you should be talking to clients about. Especially for those that are in tax traps, as the rates of return can be staggering.
Here is how pension tax relief works…
This works in two main ways, dependent on the scheme – Relief at Source (RAS) or Net Pay.
Using either method will reduce a client’s Adjusted Net Income (ANI) which is used in calculating the availability of a client’s personal allowance, ergo, their liability to taxation. This is broadly speaking the taxable income less certain deductions. You can reduce ANI by trading losses and gift aid contributions. But a main reducer of ANI is making a pension contribution. The gross value of a pension contribution made by a member or a third party on their behalf will also reduce this. Note: employer contributions will have no effect on the ANI.
Relief at Source (RAS)
Under RAS, basic rate tax relief is applied to a member’s payments to the scheme, irrespective of the member’s marginal rate of taxation. For non and basic rate taxpayers no further action is needed. Higher and additional rate taxpayers will have to reclaim further tax relief via self-assessment on their tax returns.
How RAS works
In essence a member makes a payment to their pension scheme and the government will top this up by the basic rate tax that is assumed to have already been paid by the member. In actuality the pension scheme will add the money to this and reclaim this from HMRC. Whilst basic rate tax is taken at 20%, you actually get 25% added to the premium that is paid. This is a function of the mathematics to put the member back in the position that they would have been on the assumption that they have already paid basic rate tax (BRT). If you have £100 that is subject to BRT, the net amount that you receive is £80, therefore to put an £80 contribution back into the position it would have been you have to add back the £20 deducted (which is 25% of £80).
The above graph shows the position for a BRT, so turning £80 in £100 is a very valuable rate of return for the member. It’s important to remember though, that assuming no growth the client would not get this £100 if they are a BRT in retirement. They should be able to take 25% of this as a tax free pension commencement lump sum (PCLS) with the remainder taxed at 20%, this would give them a net £85 from an £80 payment. Is this a risk free return on their money of 6.25%? Investing the money wisely could increase this, although as we know the value of investments can go down as well as up.
The client’s rate of taxation not only at time of paying the premium, but at the time of taking the benefits is important to factor in to assess the benefits of the tax relief granted. In the above example a higher rate taxpayer could reclaim an additional £20 in their tax return, and an additional rate taxpayer would be able to reclaim £25. Assuming that they were BRT in retirement then the ‘risk free return’ for them becomes 41.67% and 54.55% if you factor in the true cost of making the contribution via self-assessment.
The above is based on UK rates of taxation, the changes to the Scottish Rate of Income Tax (SRIT) creates differing rates of return and tax relief that can be reclaimed. For those paying above basic rate, they can reclaim the difference between the RAS granted and their marginal rate of taxation.
The basic rate relief under a RAS scheme is automatically granted once the premium is received, this will also apply for non-taxpayers. RAS schemes are the only schemes where those without relevant earnings can pay in £3,600 gross and get relief.
Net Pay schemes are held under occupational rules (Defined Benefit or Money Purchase) and the member’s contribution is taken from gross salary, so these do not have tax paid before the premium is paid to the scheme. There is also no need for the member to reclaim higher or additional rate tax, as this is effectively taken care off as the premiums have not gone through the taxation process.
How Net Pay works
The members contributions are deducted by the employer from the gross salary, therefore the members premium is paid to the scheme gross. The effective rates of tax relief and exiting of tax traps (as detailed below) will work whether under RAS or Net Pay.
Retirement Annuity Contracts (RAC)
For clients that still have the ability to contribute to a RAC, the premiums made to this are gross, but after the client has suffered taxation. The method of reclaiming tax relief on these would have to be sorted via self-assessment on a tax return i.e. relief on making a claim.
Note: a client must have taxable income to reclaim tax in their return. Therefore, non-taxpayers cannot reclaim any further tax. However, there may still be advantages to paying into a RAC such as valuable annuity rates that may make this an acceptable price to pay for your client.
Tax Trap Planning
The effective rates of return on the premium paid to a pension can be greatly increased if you have a client that is within a tax trap. Whilst Elvis may have made a lot of money from being caught in a trap your client is likely to become poorer, getting out of the trap will enhance your client’s wealth. Full details of these traps and various other planning considerations can be found on our PruAdviser website. The two tax traps are highlighted below:
Personal Allowance Trap
Clients with ANI between £100,000 and £123,700 will lose £1 of personal allowance for every £2m taxable as income above £100,000. This gives them an effective rate of taxation of 60% (or 61.5% for SRIT) when they would probably expect to be higher rate taxpayers (40%) based on their earnings.
Therefore, making a pension contribution to bring their ANI down to £100,000 will effectively give them 50% more relief than they would imagine when you factor in the reclaiming of the personal allowance
Child benefit Trap
Child benefit can be withdrawn (via a tax charge) on a tapered basis for households where an individual or their partner (those that are married, in civil partnerships or couples living together as married) has an adjusted net income of above £50,000. The child benefit is withdrawn as a tax charge which is calculated as a 1% taxation on the total child benefit received for every £100 of ANI above £50,000.
As with the personal allowance trap a pension contribution can reduce ANI, avoiding this tax trap. The rate of relief on this can vary depending on the amount of child benefit that is due. But the effective rate can be far higher than the 60% detailed for the personal allowance trap. It’s 50.8%, 57.9%, 65% and 72% for those with 1 to 4 eligible children respectively. These rates don’t take SRIT into account.
Summary of the traps
As detailed earlier, the tax relief on pensions is very valuable, but this adds extra value to the effective rate of tax relief. Would your clients be more tempted to bring out the cheque book when this is explained to them?
The Annual Allowance
Of course, like bacon and eggs or Laurel and Hardy, tax relief also comes with annual allowance when pension planning is to be undertaken. Once you have identified the tax position of potential contributions you need to identify the annual allowance position of your clients. Any contributions breaching this would incur a tax charge which would effectively reduce the relief.
Understanding tax relief and how this operates is a key principle in pension planning. Whilst a higher rate taxpayer may have a large lump sum that they can invest, would they be better investing this over two (or more) years if the contribution would only attract a small portion of higher rate relief?
For further information about retiring or topics like receiving a windfall, take a look at Prudential’s Life Events hub on PruAdviser.