Budget 2016: Why pension tax relief won’t be changing

How many Chancellors does it take to change a light bulb? None, if the bulb doesn’t need changing. We expected today’s Budget to radically overhaul pension tax relief – but now this change isn’t going to happen after all. So here’s a reminder of why our current system is such a bright idea.

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If it ain’t broke, don’t fix it, as the saying goes. The Chancellor was set to offer us yet another pensions revolution (they’re like Pringles) when he was bombarded with objections and backed down. His last pension reform was almost universally popular, but if pension freedom was Osborne’s ‘Hey Jude’ then a shake-up of tax relief looks more like his ‘Frog Chorus’. People weren’t buying it.

But all this fuss could be a good thing – by reminding us to appreciate what we have. So what do we have?

Pension tax relief – how it works

When you pay money into a pension, the amount is immediately boosted by tax relief. For instance if Esme (a basic-rate taxpayer) makes a contribution of £80 into her pension, and then immediately checks the balance, she finds £100 in there.

Why? Because Esme is taxed on all her income (above the personal allowance) at 20 per cent. But pension contributions are free of tax, so any money you pay in is treated as if you’d never been taxed on it in the first place – so the government gives you that 20 per cent back.

The amount of tax relief you receive is determined by your highest rate of tax – so Sally, a higher earner who pays income tax at 40 per cent, only has to pay in £60 to find £100 in her pension pot.

So it’s like free money?

Yes, near enough. A basic rate taxpayer gets an extra £20 for every £80 they invest, while a higher rate taxpayer gets £40 for every £60 they invest. And remember, this is up front, so all that extra money will start to earn compound interest from the moment you make the contribution. That’s why a pension started early enough can build over time into an impressive pot of money, even if the individual contributions aren’t that big.

Does up-front tax relief make that much difference?

The difference can be spectacular. For instance, suppose Esme starts her pension as soon as she starts working, age 21. Let’s say she pays in just £100 a month for her entire career (though realistically she might increase that when she starts to earn more). The monthly payment into her pension is actually £125 (because £125 taxed at 20 per cent would be £100). Assuming 4 per cent average compound interest, what would her pension be worth by the time she’s 55?

Monthly payment: £100
Tax relief at 20 per cent adds: £25
Total monthly contribution: £125
Interest: 4%
Number of years of compound interest: 34
Size of pension pot at age 55: £109,000 (approx.)

 

Esme would be sitting on around £109,000 (with probably ten years of saving to go before she retires). But what if she hadn’t received that up-front tax relief? What if we run the calculations again, but with each monthly contribution staying at £100?

Monthly payment: £100
No tax relief!
Interest: 4%
Number of years of compound interest: 34
Size of pension pot at age 55: £87,300 (approx.)

 

The total when Esme is 55 is just £87,300 – a difference of £22,000.

But here’s the thing. The actual difference in money paid into the pension is just £10,200 (that’s the difference between paying in £125 a month for 34 years and paying in £100 a month). The remaining portion of that £22,000 comes from compound interest paid on that money – a cool £11,800. That’s right – the additional interest paid on the ‘free money’ ends up being more than the free money itself.

Higher-rate taxpayers, take note!

If you’re a higher-rate taxpayer (earning £42,385 or over) then there’s even more reason to love your pension. Yes, you get double the tax relief, but the benefits are actually even better than that. This is because only some of your income is taxed at 40 per cent – but all of your pension contributions get 40 per cent tax relief.

Take Sally. She started her career as a basic-rate taxpayer, but then she got a promotion. Her new salary is £42,500, making her a higher-rate taxpayer. However, just a tiny fraction of her annual salary (£115) rises above the threshold, so she only pays 40 per cent tax on that part (everything else above her annual allowance is taxed at 20 per cent, like Esme).

Now can you see what a huge advantage Sally has? She’s not really paying much more tax than Esme at all, but receives double the tax relief from the government.

If Sally’s pension is otherwise identical to Esme’s, but she gets her pay rise aged 31, then see what happens to her pension as a result of higher-rate tax relief.

Monthly payment: £100
Tax relief at 40 per cent adds: £66 (from age 31)
Total monthly contribution: £166
Interest: 4%
Number of years of compound interest: 34 (24 of which are during higher-rate tax relief)
Size of pension pot at age 55: £128,960 (approx.)

 

Sally’s pension balance at age 55 becomes £128,960 – nearly £20,000 more (around half of which is just additional interest) even though her contributions were exactly the same as Esme’s. In a real-life scenario, of course, Sally would probably increase her contributions when her salary rises, making the difference even more dramatic.

So do we get to keep the current system?

For now, yes we do. But it’s still probably that the Chancellor (or someone else) will look at reforming the tax relief system at some point in the future. One suggested alternative is an ‘ISA-style’ pension or pension ISA, where withdrawals are tax-free but there is no up-front tax relief.

Anyone who has seen what a difference up-front tax relief can make is unlikely to embrace the idea of a pension ISA. So we should be glad we can hang on to our current system, and celebrate by using it as much as possible (while it lasts).

And remember – if you’ve just cross over into the higher-rate tax band, then there’s no better time to start shovelling money into your pension!

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