How Higher Earners Can Embrace the Pension Tax Relief Cuts

On 16th March 2016, George Osborne will announce the Budget for the 2016/17 financial year. It’s expected he’ll announce cuts to tax relief on pension contributions for higher earners, in favour of a new fixed-rate.

These cuts are part of the efforts to decrease the Government’s tax bill; pension tax relief currently costs the Treasury £34.3 billion in total, with the higher rates (40-45%) estimated to cost around £7 billion each year.

Under current rules, you’re awarded tax relief on your private pension contributions at the same percentage of income tax that you pay. For example, if you pay 20% income tax, you get 20% tax relief.

But many are predicting the 40% and 45% tax relief rates will be abolished, and a new fixed-rate introduced regardless of salary; figures of 20%, 25% or even 33% are said to have been considered.

 

George Osborne Lee Davy

 

Who will be most Affected by these Changes?

These changes will impact higher earners most – those earning salaries that put them in the 40% and 45% tax brackets.

If you’re a standard income tax payer, these changes will no doubt be welcomed; should the fixed rate of tax relief be set above the current 20%, it will be more beneficial to building a healthy retirement fund.

However, if you’re in one of the higher tax brackets and make fixed-contributions to your pension plan, you’ll start to see these changes immediately impact your take home pay. As contributions are set at a percentage of salary, with a lower rate of tax relief offered the shortfall will have to be made up from your wages.

Not only will higher earners see their take-home pay fall, but because retirement income is taxed when drawing it from your pension fund (whether through income drawdown, an annuity or other method), many feel like they’re being punished for earning more – effectively being taxed twice.

 

How you can Embrace these Changes in Retirement

Although it’s true that cutting tax relief for higher-rate tax payers will reduce take-home pay during their working life, many could actually be better off in the long-term.

Unless there are changes to taxation post-retirement, there are some clear ways to reduce your tax bill in retirement – more than making up for the tax relief that’s expected to be lost.

For example, let’s work on the assumption that the new tax relief rate is set at 25%. Thanks to the new pension freedoms, you can now choose to draw your retirement income at the rate you choose via pension drawdown.

You’re still required to pay income tax at the marginal rate in retirement:

  • Nil-tax – Draw an income below £10,600 (the 2015/16 personal tax allowance)
  • 20% tax – Draw an income between £10,601 and £42,385 per financial year
  • 40% tax – Draw an income between £42,386 and £150,000 per financial year
  • 45% tax – Draw an income above £150,000 per financial year

If you decided to keep your yearly retirement income below the higher rate tax threshold (i.e. less than £42,385 per year), you’ll only pay the standard rate of tax at 20%.

That means, you’ll be awarded 25% tax relief on your pension contributions during your working life, but only pay 20% tax on this in retirement.

And if you’re really frugal, and can survive each year below the income tax personal allowance threshold, there’ll be no income tax to pay on any of your retirement income – but you’ll still receive tax relief on the contributions during your working life!

 

Ryan Smith, My Retirement Options – helping those approaching retirement make better choices about their pension income and providing direct access to advice on pension drawdown, annuities and other retirement income options.

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