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Don’t underestimate the power of pensions

Rob Morgan
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Unlike ISAs, income tax relief is available on your pension contributions. This can be a significant advantage. (Source: Shutterstock)

Whether you are new to investing or nearing retirement, pensions are likely to be an important consideration. When you make a contribution to your pension, the government adds money. This is called tax relief and is one of the main advantages of using a pension to save for retirement.

Not everyone is aware of this special helping hand offered to pensions, but it can have a considerable impact on the size of your retirement funds and your income in retirement. What’s more it doesn’t matter if you’re not earning or paying tax. If you are a UK resident and under 75, you’ll still receive some tax relief.

How pension tax relief works

In the 2017/18 tax year, an investor can receive up to 45 per cent tax relief when they make a contribution to a personal pension such as a SIPP (Self Invested Personal Pension), with 20 per cent paid by the HMRC into the pension and any higher and additional rate income tax reclaimable.

For example, an investor contributes £8,000 into their SIPP and £2,000 is claimed back from HMRC by the pension provider. A higher rate tax payer could claim back up to a further 20 per cent via their tax return, reducing the overall cost of the contribution to as little as £6,000. In the same instance, additional rate tax payers could claim back up to a further 25 per cent making the cost just £5,500 for a £10,000 contribution.

Contribution limits

Tax relief on your personal contributions is limited to 100 per cent of your relevant UK earnings. Contributions, including those paid by your employer, are also subject to the annual allowance, which for the current (2017/18) tax year is usually £40,000.

Those with ‘adjusted’ income over £150,000 for this tax year have a reduced annual pension allowance, the minimum being £10,000. There’s also a lower annual allowance for those that have started to access their pensions flexibly, for example by taking an income through drawdown. This is known as the money purchase annual allowance (MPAA) and is currently £4,000 per tax year.

If you haven’t used your full annual allowance from up to three previous years, you might be able to carry it forward and use it in the current tax year provided your earnings are high enough and you have been a member of a registered pension scheme in those preceding years. People earning more than £40,000 in the 2017/18 tax year who wish to maximise pension contributions may be able to take advantage of this. There’s guidance and examples here.

Non-tax payers can contribute £2,880 to a pension in the current tax year and receive tax relief of £720, resulting in a total contribution of £3,600. In addition to upfront tax relief, money in a pension is free from capital gains tax or any further income tax on the investments.

Remember, the tax treatment of pensions depends on individual circumstances and is subject to change in future.

Is a pension better than an ISA?

For those who need access to their money before age 55, an ISA offers greater flexibility. At present, pension benefits cannot be accessed until this time, and this minimum age is set to rise in the future. For those choosing a savings vehicle for retirement the decision is a trickier one. Many investments are available in both ISAs and pensions.

Assuming that investments grow at the same rate in both a pension and an ISA account, in the majority of cases the benefit of upfront tax relief at a person’s highest income tax rate means investing in a pension works out mathematically better. This reflects the fact that pension tax relief on the way in makes an important contribution to overall return. The fact that you can generally take 25 per cent as a tax-free lump sum before drawing the pension also helps.

The main exception to this is for a basic rate taxpayer funding a pension and then becoming a higher rate taxpayer when taking benefits – a situation that could arise if an entire fund is taken in a lump sum. In this scenario an ISA would produce a better overall return. However, given that it is possible to take periodic income or variable lump sums from pension pots there is scope to plan how to withdraw money tax efficiently.

Take advantage of pension tax relief while it lasts

As it stands today a pension remains the financially more appealing retirement investment vehicle for most people including those remaining in the same tax band, or dropping down a tax band or two, once they draw their pension.

However, no one can be sure of pension rules in the future. Tax relief may become less generous, especially for higher earners. For instance, a flat rate incentive of between 25 per cent and 33 per cent for all pension contributions has been suggested. It may make sense for some people to secure pension tax relief in its current form while it lasts.

This article is solely for information purposes and does not constitute advice or a personal recommendation. It is based on rules in the 2017/18 tax year and the taxation of pensions and the rules surrounding them could change in the future. Please note this article refers to pension tax relief in personal pensions. If you’d like to learn more about how pension tax relief works with workplace or other pensions, visit the HMRC website at If you are unsure as to whether an investment or a pension is suitable for you, please seek professional financial advice.

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