Before Mr Javid’s departure it was rumoured that the government was looking to cut higher rate pension tax relief from 40% down to 20%. It remains to be seen whether this happens in the next budget in March 2020, but it might be a good time to consider topping up.
As it happens, when it comes to your finances and investing your hard earned money, knowledge really IS power. The fact that there’s a possibility of a change may make you consider bringing forward any contributions that you were going to make, to now, before the decision is announced.
Having thought a lot about why pension tax relief matters – it all boils down to one thing. Once you get the benefit it cannot be taken away. That’s why I have been greedily socking away every £1 I can afford to take advantage of higher rate pension tax relief now. When they hand me my 40% tax back, there’s no mechanism for recovering it. Similarly, when you put money into an ISA, there’s not likely going to be a way that the government would reverse your existing contributions and make you start paying tax (unless we were REALLY in the doldrums!)
As a higher-rate pension contributor my effective tax rate is around 30% when you account for the pension tax relief. Let me explain!
What is pension tax relief?
There are a lot of explanations about pension tax relief, but first let’s define pensions more broadly.
First let’s distinguish between two things: pension contributions that you make as part of your salary through an employment arrangement. Often this is either statutory (the new auto-enrolment rule where employers make 1% contribution) or voluntary (your employer pays 5% contributions if you pay 4% of your salary, giving you 9% total into your pension). The latter is a no-brainer and you should always sign up to your employer’s pension scheme.
However, that is pretty standard and not what pension tax relief refers to. The second thing is pension tax relief that you get for contributions you make over and above your standard employer/employee pension scheme.
What this is referring to is another way to get free tax back from the government. This slightly hidden benefit costs HMRC and the treasury £46 billion (with a b!) each year to service the scheme.
Pension tax relief is given to you at-source when you make deposits into a registered Self-Invested Pension Plan. You can open a SIPP through established brokerage services like AJ Bell. This is a separate private pension that you are allowed to contribute to, and the money will be kept until you are 55 years of age or older. In return for saving and being a ‘good citizen’ that won’t require loads of benefits in the future, the government gives you free money in the form of tax breaks.
And even better, as a benefit, if you are really motivated you can move your old pensions and centralise them into this one SIPP account.
Tax relief at 20% or 40% depending on your income
There are very detailed guides at the brokerage houses on exactly how this works. In a nutshell, there are two common scenarios.
Scenario 1: you are an average employee earning between £20,000 to £50,000 per year
In this case you can make deposits into a SIPP (self invested personal pension) account and for every £800 that you deposit, the government will deposit £200. That means in total the account will have £1000 in it. In effect the government “gives back” your 20% tax and allows you to immediately invest it in the account. The main catch to that is the money will be locked away until you are 55 (and it may be 57 by 2028 when new rules kick in).
Scenario 2: you are a higher rate tax earner between £50,000 – £150,000
In this scenario then for your income up to £50,000, you can still make deposits into a SIPP account (as in scenario 1) and get your 20% tax relief back.
However it is even better than that: for the 40% tax that you pay in the higher tax bracket, you can get that 40% tax back in the form of pension tax relief.
For example: if you earn £60,000 per annum then you pay higher-rate tax on £10,000 of your gross salary. If you deposit up to £8000 into a SIPP in a given year, then the government will add £2000 in regular pension tax relief. In addition a further £1600 in higher rate tax relief will be paid back to you through your tax code. At the end of the year your £8000 after-tax contribution means you’ve had £11,600 in benefits to invest in your pension. The £3600 is pretty close to the 40% tax you would pay on your earnings above £50k!
The only catch is that you only get pension tax relief at 40% for the amounts you make over £50,000. The rest is simply 20% tax relief and it is deposited directly into your SIPP account.
Key facts for SIPP accounts:
For a full review of Self-invested personal pensions please have a look here, for our beginner’s guide. Otherwise here is a quick overview of the key facts to remember:
- Maximum contribution of £40,000 per year
- You cannot contribute more than your salary (e.g. if you earn £15k, your limit is £15k)
- It is not accessible again until age 55 (which is 57 by 2028)
- Brokerages charge a fee, so go with a reasonably priced provider like AJ Bell
- Higher rate pension tax relief might get cut – so act soon!
Nobody has a crystal ball and can advise you about what is going to happen in the future.
As I sit down and write this, there is an odd calm that washes over me. I have been investing in financial markets for nearly 11 years and I suppose I have gotten bored from all of the initial excitement. Rather than worry about changes in the future, take advantage of what the government offers you now.
Your employers offer you pension schemes that give you free money – join them.
Your government offers you pension tax relief, so sign up and deposit money into a SIPP – before they cut tax relief, particularly for higher earners. 20% pension tax relief should be safe this year.
Finally, if you have money left over after maxing out on your pension contributions, then put your money into an ISA. You can deposit £20,000 per year and the interest/dividends earned on that are all tax free, and will be tax free forever. The FTSE All-Share (British index) yields a healthy 4%, which is 5.3x the bank of England base rate of 0.75%. If you’re 34 like me, I bet that will yield something like 8-10% by the time you are 67 years old. Imagine earning 8-10% per year tax-free income in your retirement years.