Pensions saving and Tax

As I explained in my previous posts I am in the accumulation stage of my retirement planning, i.e. I'm trying to build up a fund for my future retirement whilst still spending money on the good things in life. This post is about why I decided saving via a pension is the best way of building up a pension pot.

Although my decision is really tax driven I first had to think about non  - tax considerations, in particular: 

• I'm prepared to save via pension contributions because I'm prepared to tie up the investment until retirement age.  As I'm 48 years old I can access my pension savings in seven years at age 55. (Although if you are currently 40 or under you won't be able to access pension savings until you are 57 or maybe later.)

• I'm not interested in buy to let, as a way of building up a retirement pot.  If buy to let had appealed then I would probably have to do this outside a pension as its difficult to use pension savings to invest in residential property.

• When I get to retirement I'm quite happy to draw down my pension as a steady (ish) stream of income, I don't want to draw it all down in one go and buy a Lamborghini.  Even in George Osborne's new pension world, there is still a tax cost to taking your retirement pot in one go.  So if you aim to invest your retirement pot in, say, a business then you might want to consider a vehicle other than pensions.   

Because I'm not fussed by these non  - tax considerations I'm free to judge using a pension as a savings vehicle on its tax treatment, and I think there are compelling tax reasons to save via a pension. The UK pension system is often described as an "EET" regime this is because:

When I save money in to a pension then the income I save it from is tax  Exempt   

As money builds up in the pension it is tax                                              Exempt

When I take money out of a pension it is                                                Taxed

Although EET is a good way of thinking about tax and pensions the system is actually more generous than that.

• Firstly not all of the pension is taxed on the way out, it is possible to take 25% of the final pension pot as a tax free lump sum.  This is good news, I get tax relief up front for my pension but I am only partially taxed on the way out.  

• Secondly it is possible that retirement income will be taxed at a lower rate than earned income.  (This isn't a factor for me as I earn via my business that pays tax at 20% but may be relevant if you are employed. Then you may be able to save in pension,  reducing  income currently taxed at 45% or 40% and pay tax at 20% when you draw the income down in retirement).

Just to prove to myself that this all works I did a little numerical example that compares ISA investing with pension investing.  Assuming that the individual doing the saving pays tax on income earned now at 40% but suffers tax on future pension income at 20% then saving in a pension rather than an ISA can increase the income in retirement by 25%. I have deliberately left national insurance out of the example, as that will be the topic of a later post.

(Hopefully) You can download the spreadsheet from the link below.

ISA vs Pension

In my situation the figures don't look quite so good  (I maybe get 10% more income from saving via a pension than in an ISA compared to the 25% + for a 40% tax payer) but it still seems clear that pension saving is the way to go.

There are however a couple of drawbacks from saving via a pension.

• Although money builds up in a pension tax free this tax exemption is not complete.  If you invest in equities then it is likely that the companies you invest in will have already paid tax on their profits.  At one stage pension schemes could claim a tax credit from the government when they received UK dividends to compensate them for the tax the company paid on profits, but Gordon Brown stopped all that.  Although this is a bad thing, ISAs are similarly unable to claim back  tax paid on company profits so it doesn't change the comparison.

• Although the tax rules for pension saving are generous there are restrictions on the amount that can be invested in a pension and the total amount of pension saving that can be accumulated.  My next post will be on these rules.