The tax reliefs for pension contributions are there to encourage you to provide for your retirement. Most people struggle to save enough to provide a comfortable income after retiring. Declining annuity rates in recent years mean you have to save even more. For example, a 65-year old retiring today needs a pension pot of £450,000 to provide an annual pension of £25,000. A larger pot is needed for an index-linked pension, or to provide a widow’s pension.
You can contribute up to 100% of your current earnings to a maximum of £50,000 (for 2012/13 and 2013/14), and get tax relief on the full amount, but any contribution from your employer must be deducted from that cap. If you have contributed less than £50,000 in each of the last three years you can pay extra in the current year to catch up. However, the cap for 2014/15 will be reduced to £40,000, so if you want to maximise your pension fund, you could consider making extra contributions before 6 April 2014.
Tax relief for personal pension contributions is given at your highest rate of tax, but in two stages: you pay a contribution net of basic rate tax, let’s say £800. The pension scheme then reclaims 20% tax from HMRC, which results in a total of £1,000 of investments held in your tax-free pension fund. As a 40% taxpayer you claim an additional 20% tax relief through your self-assessment return (and a 50% taxpayer gets a further 30%). So the investment of £1,000 actually costs you £600 (or £500).
Some employee contributions enjoy tax relief by deduction from pay before PAYE is applied. Some older ‘retirement annuity policies’ still require the payment of 100% of the premium to the fund, with all the tax relief claimed through self-assessment.
The money is saved up to give you a tax-free lump sum of up to 25% of the fund when you take the pension benefits and a taxable income after that. Although there are big tax breaks in this sort of saving, unfortunately you can’t get access to the whole of the tax-sheltered fund on retirement, and that makes it unattractive to some people. You should take advice about the options available.
For those lucky enough still to be in a final salary pension scheme – including many teachers, civil servants and health service workers – the annual limit is measured by comparing your entitlement at the beginning and end of the year. To find the value, you multiply the accrued pension by 16, even though current annuity rates suggest the figure should be higher. Inflation is taken into account, which makes the calculations complicated – but a relatively small increase in salary, multiplied by 16, could put the increase in benefit over £40,000. Members of final salary schemes will have to keep a close eye on the effect of the contributions cap.