For many people in their 30s and 40s, retirement seems like an awfully long way away. So, when we speak to these clients, pension planning sounds like something in the dim and distant future rather than a concern for them at this stage of their life.
What often goes forgotten is that pensions are one of the single best ways to invest money. From the benefits of compound growth to the huge tax advantages, they are a great way to build up wealth.
And, without taking pensions seriously, you might reach retirement without the money you need to enjoy the things you want.
It’s vital that you start saving early
One of the simplest and best ways to ensure you can achieve the lifestyle you want in your retirement is to start saving early.
If you begin your contributions in your 20s or 30s, not only will you pay into your pension for longer, but you’ll also get the benefit of compound growth – essentially growth on the growth – a phenomenon Albert Einstein described as “the eighth wonder of the world.”
Here’s an example. Research by the BBC looked at how much money an individual would have to contribute every month to get an eventual pension of £20,000 a year, depending on the age they start saving.
If you start saving at the age of 25, you would need to put away £246 a month, net of tax. For the UK’s average earner, this is around 14% of salary. After 20% tax relief, that sum is actually worth £307.
If you waited until 35, this figure would rise to £404 per month – around 23% of the UK’s average salary. At 45, you’d have to contribute £826 a month as a man, or £861 as a woman – almost half the average earnings in the UK.
Note that these calculations are based on a complex model that predicts the investment return over the lifetime of the pension. Assuming it achieves investment growth of a typical default investment strategy, and assuming the eventual pay out increases annually with inflation, as well as granting a 50% income to a surviving partner, this level of saving has a 50/50 chance of providing an annual income of £20,000 or more.
Here’s another way of looking at the benefits of starting early.
This table shows the value of a £500 per month investment over varying terms to age 65, assuming 5% investment growth each year.
As you can see, a delay of just five years in starting contributions can have a massive impact on the final fund. In this example, five years’ worth of contributions totals £30,000, yet the impact of that money not being invested means a drop of around nearly £120,000 in fund value at age 65.
If you’re already contributing to a pension plan, consider increasing your contributions, and review the amount you put in each year as your earnings increase.
The table below shows the value of increasing regular contributions by just 3% each year. Even just a small increase each year can make a substantial difference to the final value of your pension fund. Again, this assumes 5% investment growth each year.
The 5 tax benefits of pensions
Many of our clients understand the tax benefits of Individual Savings Accounts (ISAs) and many pay into an ISA. While ISAs offer some useful tax efficiencies, these do not compare favourably to the tax benefits of pensions.
- Tax relief on your contributions
To encourage pension saving, the government gives tax relief on what you put in up to a certain limit.
If your pension contributions are coming out of your salary before tax, they won’t be counted as part of your taxable salary and so you won’t pay any tax on them. You effectively get tax relief at your highest marginal rate of Income Tax.
If your pension contributions are paid out of your after-tax salary, your pension scheme will automatically add basic-rate tax relief to your contributions. If you pay higher or additional-rate Income Tax, you can reclaim additional tax relief through your annual self-assessment tax return.
This means a £100 pension contribution will effectively cost you:
- £80 if you pay basic-rate Income Tax
- £60 if you pay higher-rate Income Tax
- £55 if you pay additional-rate Income Tax.
Even non-taxpayers can still claim basic-rate tax relief on contributions up to £2,880 (£3,600 including tax relief).
You could also consider ‘salary sacrifice’, where you give up part of your income for another benefit – such as a pension contribution. When salary sacrifice is used to put money in a pension, the 12% National Insurance (NI) is not payable. Additionally, the 13.8% employer NI is also not payable and, often, a company will pass on some or all the NI savings to the employee as an extra pension contribution.
So, as a basic-rate taxpayer, you could benefit from 20% tax relief, a 12% National Insurance Contribution saving and, potentially, a 13.8% company National Insurance Contribution saving – a potential return on investment of 45.8%.
- Your investments grow tax-efficiently
The contributions you make to your pension grow largely free of taxes when invested. The favourable tax treatment of pension funds means that they should grow faster than equivalent taxable investment funds.
- You can take a tax-free lump sum
When you reach pension age – normally age 55 – you can typically take up to 25% of the value of your fund as a tax-free lump sum.
- Potentially no UK Inheritance Tax to pay when you die
If you die before the age of 75, money in a Defined Contribution can be passed to your beneficiaries tax-free (as long as they take it within two years). After age 75, the money is taxed at the beneficiary’s marginal Income Tax rate.
- Tax benefits when transferring your pension to a super
In Australia, superannuation contributions are taxed on the way into the scheme. Investment growth is also taxed but, when taking the super out as income, it is tax-free.
In contrast, in the UK, contributions are not taxed on the way into the scheme and investment growth is not taxed. However, all but 25% of the fund is taxed on the way out.
This means that if you can transfer your UK pension to superannuation, it is possible to pay little to no tax at each stage.
Get in touch
As a cross-border financial planning firm with offices in both the UK and Australia, we’re uniquely placed to help you with your financial and pension arrangements. Get in touch to find out how we can help.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.