17 Feb Turning Pension Contributions into Tax-Free Income
Tax-advantaged investments come in all shapes and sizes. Some offer tail-end tax benefits, e.g. ISAs, i.e. there’s no tax advantage for investing, but your money grows tax free. Other schemes such as venture capital trusts and enterprise investment schemes offer mainly front-end advantages, i.e. you get a tax credit for your investment. The trouble is these involve relatively high-risk investments. Personal pensions, on the other hand, offer both front-end and tail-end tax breaks with relatively low risk.
There are of course some drawbacks with pensions, the main one being that you can’t get at your money until you reach 55. However, depending on your age, and as the following examples show, you should think of pensions as a medium to long-term investment and not just something for your retirement.
Example 1 – ISA. James is 48 and a higher rate taxpayer. His income recently increased and he wants to invest some of his new found wealth. He’s considering a stocks and shares ISA, which after admin charges will return, say, 4% (tax free) per year. If he invests £10,000 per year for seven years his ISA will be worth a little over £82,000 – a 17.5% growth on the amount invested, which James can take tax free (see The next step ).
Example 2 – pension. If James invested £10,000 per year in a pension, assuming the same rate of return as the ISA, his savings would be worth almost £137,000 after seven years. However, if he were to withdraw it all at once 75% of it would be taxable, and assuming he is still liable to higher rate tax he would receive £95,000 net – a 37% growth on the amount invested. That’s a vast improvement on the ISA and it’s the tax breaks for pension savings that make all the difference (see The next step ).
Trap. Depending on the level of James’s other income he might need to split taking the pension savings between two tax years to avoid having to pay additional rate (45%) tax. He could do this by, say, taking half his pension fund at the end of March and the other half sometime after 5 April.
Spread the investment
If James is happy to lock his money in until he’s 55, then choosing to invest in a pension over an ISA, or other low-risk investments, is a no-brainer. But if he has a wife or partner with a low income he could do even better out of a pension investment.
Tip. While pension contributions are usually only permitted if you receive earnings from work, the rules allow an investment of £3,600 per year regardless. Contributions can be paid by anyone and the usual tax breaks apply.
Example 3 – partner’s pension. If James invested the maximum £3,600 per year for seven years for his partner, who has no other income apart from £6,000 of bank interest and dividends, the savings would be worth £29,500 and be tax free after seven years – that’s a 47% growth on the amount invested (see The next step ). Is it time you took a fresh look at pensions?