A bird in the hand is worth two in the bush. This is what it may feel like sometimes whenever we decide to use our hard-earned money to enjoy life to the full while we’re still young rather than save for the future.
We’ve all been there at some point in our lives, most probably. It’s only human. And the government knows this full well, which is why it throws out a few carrots to encourage us to save more for our retirement, so we can be more self-sufficient in our long-term pursuit of healthy, happy lives.
Of course, not everyone is a big spender, even if we could be – we don’t all hanker after haute cuisine and haute couture. Many of us are relatively frugal. But that’s even more reason to take advantage of the various government tax incentives that could help you retire with more money and, potentially, also at a younger age, so you can continue to live life to the full.
To spend or to save? It’s all about balance. To help you find your own happy medium, here’s a step-by-step run through the pension-related incentives currently available under UK legislation and how they might apply to you:
Basic tax relief on pension contributions
As it stands, up to £40,000 of untaxed income can be paid into most people’s1 pensions each year. This means that if you pay tax at the basic rate of 20% and £32,000 in net earnings is paid into a pension, the government will top that up by a further £8,000. In effect, it will give back the income tax that was paid on that money.
The above covers not just money that you pay into your own pension but also money that you might pay into your partner’s or even children’s pensions.
And it all happens automatically – the pension provider claims it back. You don’t have to do anything to get that top-up. There’s no paperwork.
Workplace vs private pensions
One important thing to bear in mind is that the annual allowance covers your workplace pension as well as any private pensions that you may hold.
The minimum that currently must be paid, by law, each year into a person’s workplace pension is 8% of their salary (5% from the employee, with another 3% contributed by the employer). But some employers voluntarily contribute and will match additional employee payments.
So, remember to deduct what you already pay into your employer’s scheme before paying into a self-invested personal pension (SIPP), if you intend to take full advantage of the £40,000 threshold2. Remember also to consider taking full advantage of any matching contributions from your employer before investing in a SIPP, as this is essentially free money.
Higher-rate tax relief
Tax relief on pension contributions is even more generous for the vast majority of higher-rate taxpayers. This is because you can claim back the extra 20% or 25% you pay HMRC through your annual tax self-assessment form, over and above the 20% that is automatically claimed back on your behalf.
Here, there is a little paperwork involved but it’s potentially very lucrative because it technically means that you can contribute £40,000 to your pension sacrificing just £22,000 of your net annual earnings.
It gets more complicated for particularly high earners with ‘threshold’ incomes above £200,000, as their pensions allowances may be tapered3. If in doubt, seek the support of a financial adviser.
What if you forgot to make as much as use of your pension allowances in previous years as you could have done, or weren’t aware that you could?
What if you were unable to due to personal circumstances – because your annual income can vary greatly, or because you were bedding in a new business that took time to move into profit, or because you were out of work for a time?
Don’t worry, the current rules on pension relief look out for you too – which is just as well, given most self-employed people don’t have access to workplace pension schemes. This is because you can carry forward any unused annual allowances from the previous tax years.
So, as long as you’re a pension scheme member in the intervening period, it is technically possible to earn tax relief in any one year on up to £160,000-worth of pension contributions. That’s a tidy sum and a very handy one if you’ve enjoyed a bumper year after a few difficult ones.
What’s more, you do not need to report this to HMRC. If in doubt, speak to an authorised financial advisor.
Retire earlier (if you want to)
Finally, when would you like to retire if you could decide? It’s an intriguing and motivating question that these days we have more power to answer on our own terms.
Leave it until you’re eligible for the state pension and you’ll be waiting until you’re aged 66 (rising to 68 if born after 5 April 1978).
Some people may prefer to wait even longer. And there’s certainly some potential benefit to that. Aside from the extra working income and possible mental and emotional benefits, delaying taking your state pension would boost the payments you later get4.
But for many us it is retiring early that is the more attractive option – and in this respect the government’s rules have become more flexible since you can start to draw money from your pension pot5 from as early on as your 55th birthday.
As a result, the money you invest in your pension or pensions isn’t locked up for as long as you might think.
And the greater flexibility doesn’t stop there because it’s also up to you how you take your money, with the first 25% incurring no tax – whether you choose to take it as one lump-sum or gradually.
Any further sums that you draw are taxed as ordinary income but here, again, you have a range of options over how to do it – from taking further lump sums, buying an annuity providing a guaranteed income for life, setting up a flexible drawdown scheme, or a combination of any of these.
As ever, it’s up to you. But the more you take advantage of the available tax benefits by investing in your pension and, the earlier you do it so your investments have more time to grow through the power of compounding, the more chance you’ll have to retire when you want and in the manner of your choosing.
Maybe those two birds in the bush aren’t so unappealing after all.
1 Your annual allowance might be lower if you’ve flexibly accessed your pension pot or you earn a particularly high income.
2 To find out what exactly you pay into your workplace pension, best check with your employer. But to get an idea, a calculator is available through the Money Advice Service, which is sponsored by the Department for Work and Pensions.
3 The government offers guidance on how to work out your reduced (tapered) annual allowance on its website.
4 See here for more details on the implications of deferring your state pension.
5 Defined contribution pensions only.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Any tax reliefs referred to in this article are those available under current legislation, which may change, and their availability and value will depend on your individual circumstances. If you have questions relating to your specific tax situation, please contact your tax adviser.
Please be aware that pension and tax rules may change in the future and the value of investments can go down as well as up, so you might get back less than you invested. You cannot usually access your pension savings or make any withdrawals until the age of 55.
If you are not sure of the suitability or appropriateness of any investment, product or service you should consult an authorised financial adviser. Please note this may incur a charge.
This article is designed for use by, and is directed only at, persons resident in the UK.
If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described in this document, please contact your financial adviser.
The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
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