What makes you save money into a pension?
I don’t mean saving for retirement in general - the need to do that should be an obvious one - but what makes you do it inside a pension rather than outside?
After all, saving money into a pension can mean denying yourself access to it for years or even decades at a time. That’s money that you could otherwise spend now, or at least have access to now even if you keep it saved in cash or invested.
The reason that locking it away in a pension makes sense is that pension money gets special treatment in the tax system which compensates you for this act of delayed gratification. The money paid into a pension is not taxed as income at that point. It can grow free of tax on gains and can be accessed in the future when 25% of it will not face tax at all. The rest is taxed at whatever rate of tax you’re paying then.
This system of tax relief - or tax deferral - means the benefit you get is determined in part by the rates of income tax you pay throughout your life. If you pay into a pension as a higher rate taxpayer but withdraw money later as a basic rate taxpayer, you have gained a bigger advantage than the person who pays and withdraws their pension money at the same rate.
For this reason some say the pension system is unfair, skewing benefits towards wealthier people.
It is an argument that has been going on for years and successive governments have mulled the idea of equalising tax relief for everyone - to make the system fairer but, potentially, cheaper too.
Now rumours of a big change to pension tax relief are flying about again. The Treasury is reported to be looking at an overhaul of the system, including the potentially dramatic move to limit pension tax relief to just the 20% basic rate. At the moment, a boost equivalent to any basic-rate tax paid is automatic while the extra available to higher and additional rate payers is either added automatically or else claimed through a self-assessment tax return.
If tax relief was limited to just the basic rate it would fundamentally change the calculation for pension saving. Higher-rate tax payers would have to decide whether the benefits of saving into a pension were still worth locking money away for. If they expected to still be higher-rate taxpayers in retirement, they would enjoy only a slim tax advantage from locking their money away in a pension during their working lives.
Even some of those who fully expect to be paying 20% tax in retirement may think twice.
Any change that leads to people saving less for retirement has to be judged a failure in policy terms given the challenges posed by an ageing population and the strain they will put on public services.
Would the Government risk that, even if it has a long list of deserving causes that the extra on pension would pay for?
At the moment, limiting pension tax relief to the basic rate seems unlikely. There are many changes short of that, however, which could come - perhaps as soon as the Budget next month. Limits to the amounts that can be held in pensions (the Lifetime Allowance) and the amount that can be contributed each year (the Annual Allowance) have already been reduced - including via the Annual Allowance Taper which means the very highest earners get severely limited benefit from the pension system anyway.
Whatever changes arrive or don’t arrive next month, it should be a reminder to ensure you are making the most of the system as it stands. Maximise your pension contributions which are matched by an employer and, beyond that, try to escalate your saving.
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Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest. Tax treatment on pensions depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55.
Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.