A thought on pension tax relief

From the comments:

There is a potential saving for some rather than simply a time deferral.

Many people will get a tax “rate” saving. For example, gain tax relief on their pension contribution at 40% but then have their pension taxed later at basic rate, etc. Ie, few people actually earn more retired than when they are working.

Intuitionally – to coin a horrible word – I don’t think so.

Say the tax rate saving is 20%, as above. OK.

So, I put £100 into my pension now. That grows at 5% a year (yeah, I know, har har) for 20 years. Without compounding that gives me £200. I then get 5% a year off that for 20 years of retirement.

I get £200 in income and pay £40 in tax on it.

My tax saving when I put the £100 in was £20.

Maybe this particular example doesn’t actually show it, or it does, whatever. But there’s definitely some combination of investment returns, lifespan and tax rates which shows me paying more tax by having pensions deferment than not.

11 comments on “A thought on pension tax relief

  1. @Tim — only possible if tax rates go up between paying in and taking out, or maybe if you get walloped at 55% for going over the lifetime allowance of £1m.

    Noddy example ignoring national insurance and putting-in/taking-out being probably in different tax bands:

    If you earn £100, pay 20% tax on it and put the resulting £80 in an ISA for 20 years at 5%pa (compounded 265%), you get £212. Tax free because it’s already had the tax paid on it.

    If you salary sacrifice £100 into a pension, for 20 years at 5%pa, you get £265. On which you pay 20% tax which gives you exactly the same £212. Because multiplication is commutative.

    The argument that can be made for pension saving is that it can’t be blown on a mid-life Ferrari, thus the government is protected from paying out means-tested benefits to some number of retirees.

  2. There is an option for you to do that because pension saving without tax relief is just saving. But possession of a sum of money in some hypothetical future is going to tempt those who want your money for themselves, and you cannot predict the future. The biggest risk to retirement provision is regulation which comes on a far shorter timescale than you can possibly plan long-term.

  3. rk has it! Investing in a pension is one hell of a gamble: to incentivise me to do it I’d need more than a tax deferral. I’d need salary sacrifice, or employer’s contribution, or the expectation of a lower tax rate on retirement, or the hoped-for avoidance of Inheritance Tax, or the dreaded death before 75 so that my beneficiary got the loot out tax-free, or the promise of an unusually attractive annuity rate, or several of these.

    I suppose you could arrange the lower tax rate on retirement by retiring to Portugal or Cyprus.

    Suppose someone contributes only his own money at 20% rebate, and then when he retires he faces a basic rate of tax at 25%. Even if the Pension Commencement Lump Sum survives he’d have been better off – because of the extra flexibility and perhaps lower costs – bunging his money in an ISA.

  4. “Suppose someone contributes only his own money at 20% rebate, and then when he retires he faces a basic rate of tax at 25%.”
    Except that all of his contributions received tax relief at the 20% marginal rate, but on receiving the pension at least part of the income is at 0%. Mind you, when the state pension kicks in (if!) then even much of that advantage disappears.

  5. Tim,

    I was talking about tax *rates*. Your intuitive example simply went and assumed the same tax rate! Ie relief on the contribution at 20% and income charged at 20%. That’s the bit I’m saying doesn’t in fact happen (on average) – because far more pension relief is given at higher rates than there are retirees paying tax at 40% on their pensions.

    In addition, pension relief is given at the highest margin (ie a 40% tax payer gets all the pension relief at 40%). But tax is later paid on pensions on the full pension range. And NDR just added another factor (the free pay element) that will mean an even lower average tax rate when taking the pension.

  6. A simple example (if it helps):

    Over 10 years you earn £100K per annum and pay £40K of that into a pension scheme. 40% rate relief on all of the contribution, tax rebate over 10 years = £160K. Total pension pot is £400K.

    Assume that inflation, interest and returns are all 0% (just so the arithmetic on the rate issue is easier to visualise).

    You then retire and take the pension for 10 years before an inheritance bails you out.

    Retirement income over 10 years is £40K per annum. 25% is the tax free lump sum and 25% is free pay (just assume free pay is £10K rather than £12K).

    The effective tax rate on that £40K is 10%. Ie £40K less £10K lump sum, less £10K free pay, = £20K taxed at 20% = £4K tax on £40K (average 10%).

    Or, over 10 years, just £40K of tax paid against £160K claimed back in rebate earlier.

    That’s the principle I was trying to make, ie a reduced average tax rate on later pension earnings.

  7. If the idea of a pension is to spread your earnings over a lifetime, it seems reasonable that you pay tax in the year that you take the earnings.

  8. Given the timescales involved and the potential for changes to the tax and pension system surely it’s hard to say with any certainty what the position is or might be at some point in the future.
    Is this just a series of hypotheticals that are being used to try and justify raising pension pots maybe

  9. Here cometh the sermon of samuelbuca’s pension reforms: (only to be enacted for people of my age and younger: > 23 year to state pension, so plenty of time to arrange accordingly)

    1. State pension shall be means tested.

    2. No limits on either personal contribution per annum or total pot of pension.

    3. Any unfunded scheme (apart from basic state pension) to be banned. No final salary schemes of any kind (mainly directed at public sector)

    That’s it. Easy. Thank you

  10. @BniC, it’s simply a way of raiding private sector pension pots. Not a word from the left on public sector final salary schemes.

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