In the run up to the tax year end I’ve been reflecting on the pension freedom regulation changes and whether the new rules, introduced in 2015, have made the use of personal pensions more attractive. I would say the answer is yes.
I further believe these benefits become much more attractive if we can gain a ‘positive tax shift’. This means that the tax rate you pay when contributing into a pension is higher than the rate you pay on receipt.
So meet Anthony. Anthony is a solicitor earning a good salary and is therefore a 40% tax payer. If he pays into a pension now he will receive £40 tax relief in every £100 of contribution. On current projections he will be a basic rate taxpayer in retirement (unless he wins the lottery), so after the 25% tax free cash he would pay 20% tax on the remaining income which equates to a total tax of 15% (20% of 75%). The result is a guaranteed return (before fund performance) of 25%.
If Anthony’s career then progressed to such that his income breached the ‘tax trap’ , with his earnings topping £123K per annum, the pension contributions made between £100K and £123K will in effect receive 60% tax relief. Every £100 he now contributes will only cost him £40. With the same tax paid in retirement as before (15%), this would give him a 45% guaranteed return (before fund performance).
Later in life, Anthony could semi-retire and become a basic rate tax payer, however he would only receive 20% tax relief. This would reduce the guaranteed return (before fund performance) to 5%.
If you were Anthony when would you be making the most pension contributions in order to receive the best positive tax shift?
If you would like more information please get in touch to arrange an initial conversation.
For a recap on the pension freedom rules check out our previous blogs:
Financial Planner & Director