Whilst pensions are commonly used by individuals to save for retirement, many people are not aware of the extent of their benefits. Pensions are a tax efficient wrapper which can be utilised by individuals. Contributions per tax year are capped at £40,000 for the majority of people. Those with lower or no incomes have their contributions limited to their earnings, or £3,600 (including tax relief), whichever is higher. Individuals are also able to utilise the past 3 tax years of contributions if they haven’t already.
The first widely known benefit of putting money into a pension, rather than just savings, is that you receive income tax relief equal to the marginal level of income tax you have paid on your contributions. This means if you are paying 40% on £100, and invest this into your pension, your pension will receive the full £100 while the income you would normally get from this is £60. When you withdraw from your pension, you are charged at your marginal rate of income tax, therefore if you are accumulating money quicker than you expect to decumulate it, it is likely you would be paying a lower level of income tax when withdrawing money from your pension. For example, you put in £100 at an income tax rate of 40% so you would have received £60 if you do not contribute it to your pension. If you do contribute it, then when you withdraw this £100, you receive £80 from your pension, as you are only liable to pay 20% income tax as your income levels have reduced. Additionally, when you retire, individuals also have the option to take a 25% tax free lump sum or get 25% of any income payments tax free, which further reduces tax liabilities when making withdrawals from your pension.
Another benefit of saving into a pension is that pensions are exempt from capital gains tax (CGT), and therefore any investments you make are not liable to capital gains tax, which is currently set at 10% for basic rate taxpayers, and 20% for higher rate taxpayers. With the capital gains tax allowance now reducing as of April 2023 to £6,000, this is even more beneficial to investors, as they would be more likely to become liable for CGT tax on their investments than they were previously, whereas they would not be liable if this money was held in a pension.
Under Auto Enrolment, employers are also required to pay contributions into your pension. Some will offer additional contributions above the legal minimum requirements. For example, they may agree that for every 1% of your salary which you contribute up to 10%, they will also contribute 10%. This would effectively double your contributions, and you are getting money from your employer which you wouldn’t otherwise receive.
Finally, a long-term benefit of building up your pension pot is that it is not counted as part of your taxable estate. Therefore, when you pass away, you can choose who you would like to inherit your pension through an expression of wish form, or similar, and that pot will not be liable to inheritance tax (IHT). IHT currently stands at 40% above your allowances. This is particularly valuable to those with large estates, as it keeps money within your control, whilst keeping it tax free for your beneficiaries.
It is important to note though, while pensions are a tax efficient wrapper, private pensions are only accessible at the normal minimum pension age (NMPA) which is currently set at 55. This means that you would need to be careful not to overcontribute to pensions with emergency funds or money that you may need before this age. At AWM we are happy to have these discussions with you to determine a comfortable level of contributions to your pension, to ensure you maximise your pension whilst maintaining a healthy current income too.
Written by: Alice Frost
Date: 23 December 2022