How to plan for a comfortable retirement: making the most of pension tax reliefs
Many people will be seriously disappointed with the income they receive when they retire. Some cannot afford to save significant amounts, but an astonishing number of people who can afford it are failing to plan effectively. In many cases, they are simply unaware how pensions and pensions tax reliefs work and have no idea of the size of pension pot they will need to maintain their lifestyle in retirement.
Won’t the State Pension be enough?
Recent research from wealth manager abrdn indicates that 20% of people retiring this year plan to use the State Pension as their main source of income. The basic State Pension is currently £141.85 a week (£7,376 a year) and the maximum State Pension is £185.15 (£9,628 a year). In an era of soaring inflation, this is not going to go very far.
I’m expecting an inheritance when my parents pass away. I’ll be fine, won’t I?
According to research by Hargreaves Lansdown, 40% of Brits are planning to rely on an inheritance to fund their retirement. This could be a dangerous game. Their parents, or the rich uncle, may prefer to enjoy their own retirement and go ‘SKI-ing’ (Spending the Kids’ Inheritance) or they may need expensive residential care in later life which can soon eat through the value of a house and savings.
Won’t my workplace pension be enough?
According to the Pensions and Lifetime Savings Association (PLSA) 26% of those with a workplace pension believe it will not be sufficient to live on when they retire. And they are probably right! Although the proportion of workers in the private sector contributing to a workplace pension has increased from 32% to 75% since auto enrolment was introduced in 2012, the minimum contributions are unlikely to deliver a comfortable retirement. As a minimum, employers must contribute 3% of an employee’s earnings and the employee must contribute 5%. Eight percent of earnings might sound lot, but according to The Private Office, it is not enough. For a 40-year old earning £30,000 a year with a state pension age of 68, the minimum contributions could produce a tax free lump sum at retirement of £42,000 but a drawdown pension of only £5,500 a year before tax.
Despite this, 51% of people believe the minimum rates will be sufficient and 77% have no idea how much they will need in retirement.
What sort of income do I need in retirement? And how big a pension pot do I need to produce it?
The PLSA has produced the following table which sets out the income which would be needed to have a ‘minimum’, ‘moderate’ and ‘comfortable’ lifestyle. The figures are for a single person living outside London.
*These amounts would fund this lifestyle for people living outside London. See The Detail for more information.
An individual living in London will need even more: £13,200, £25,400 and £36,700 for minimum, moderate and comfortable lifestyles respectively.
The two in five people who are planning to rely on their State Pension will have an annual shortfall of £1,272 which will need to be funded from other sources if they want to achieve even the minimum retirement standard. Those aiming for a comfortable retirement will need a whopping additional £23,972 a year.
Abrdn have calculated that the pension pot needed to produce the additional income required by an individual who plans to retire at the age of 67 and who hopes to have a moderate lifestyle is at least £326,000. If they want to retire at 60, that soars to £454,000.
How am I going to build up a pension pot like that?
It is important to start contributing to a pension as early as possible so that the power of compounding builds up a substantial fund by retirement age. The difficulty is, of course, that younger people are already juggling student loan repayments, rent or mortgages and school fees and everyone is affected by inflation so that there may not be anything left to put into a pension.
The other big value builder is tax relief, yet HMRC’s own research reveals an astonishing lack of knowledge about pension tax relief and how it works. The Report – Pension tax relief: awareness, understanding and saving behaviours – published in April 2022, found that 26% of adults thought the government provided no pensions tax relief and 33% did not know. Only 41% knew pension contributions are boosted by tax relief. Basic rate taxpayers who were aware of tax relief, on average thought that the tax relief top up amounted to 6% (when it is actually 25%) and higher rate taxpayers thought it was 15% (when it is actually nearly 67%). Other research shows that a staggering 80% of higher rate taxpayers and 50% of additional rate taxpayers fail to claim the tax relief due to them.
What pension tax relief can I get? And how do I get it?
Contributions by your employer to your pension scheme are tax free for you and deductible for your employer in calculating its taxable profits. It is a very tax efficient and valuable benefit in kind.
You get tax relief on any contributions you make to a registered pension scheme, whether a workplace scheme or a personal pension. Tax relieved contributions are limited to £40,000 a year and this is tapered for high earners, so a person on £312,000 p.a. will be entitled to the minimum allowance of only £4,000 a year.
When you pay a contribution to a pension scheme, you are treated as if the actual amount you pay was after deduction of basic rate tax at 20%. The pension scheme can then claim that tax from HMRC. This, effectively, gives you tax relief at the basic rate. To put £100 in your pension pot, you pay £80 and the government gives £20 of basic rate tax you have already paid back to the pension scheme.
If you are a higher or additional rate taxpayer, you can claim further tax relief at your highest tax rate through your self-assessment tax return or by contacting HMRC. If you are a 40% taxpayer, it costs you £60 in net income to put £100 in your pension and it costs an additional rate taxpayer only £55.
Once the money is in the pension scheme, it can be invested and the investment returns roll up gross: pension schemes do not pay income tax or capital gains tax on interest, dividends or capital profits.
There is a cap on the amount which can be saved in a pension. The current ‘Lifetime Allowance’ is set at £1,073,100. If your pension savings exceed this amount, you will generally have to pay a tax charge on the excess when you take your pension.
Your options for taking benefits from the scheme are much more flexible than they used to be. When you retire, you can take 25% of the fund as a tax free lump sum and use the rest to provide a pension. The pension element will be subject to income tax, but by definition, you are likely not to be working, so your tax rate may well be lower. The days when you had to take an annuity on retirement are long gone and you can now take a “flexible drawdown pension” which essentially means you can take payments of as much or as little as you want, whenever you want to take them. So if you continue to work you could take your lump sum but leave the rest of the money to roll up in the scheme. If you work part time, you could take a top up and when you retire properly, you can take a higher pension in the early years so that you can have some fun, and reduce the amount as you get older and less adventurous.
What do I do now?
A pension is a hugely efficient way of saving for your retirement, but in order to get the most out of it, it is important to understand what the benefits are, and how to make the most of them. And you should start saving as early as possible. A pension is, of course, only one element of planning for the future. Contact our Private Wealth team for more estate planning advice.