For years, pensions have been one of the most tax efficient ways to save. Unlike savings and investments such as PEPs, TESSAs and ISAs, pensions not only provide favourable tax treatment once your money is in the account, but also help you cut your income tax bill.
In the latest part of our “52 Ways to Save Tax” guide, we look at the income tax savings you can make through pensions. Keep reading to learn more.
52 Ways to Save Tax – Part 25: Cut your income tax by saving into a pension
If you want to save for your retirement and simultaneously reduce your current income tax bill, you can consider paying into a pension.
Pension contributions that you make receive tax relief at your marginal tax rate. So if you’re a higher rate taxpayer and you pay £8,000 into a pension, you will have a further £2,000 credited to your pension by HMRC. You can then reclaim an additional £2,000 through the self-assessment process, as long as you pay tax at the higher rate on at least £10,000 of your income.
In simple terms, you end up with £10,000 in your pension for a contribution of just £6,000.
Currently, the maximum amount of tax-relieved pension contributions that you can make is £40,000 per year or your annual earnings, whichever is lower. This is your Annual Allowance and it includes any contributions you make to other pension schemes and any contributions that other people make for your benefit (for example your employer).
You may be able to roll forward unused contributions from the past three tax years.
Bear in mind that your total gross contribution can’t be higher than your pre-tax income. However, if you don’t have any taxable income you can still pay up to £2,880 into a pension, and this will be grossed up to £3,600.
Factors you should bear in mind when contributing to a pension
While paying into a pension offers significant tax benefits, there are some factors that you should bear in mind.
Firstly, you need to remember that once you make a contribution to a pension, the investment is locked away until you reach the age of 55 (or age 57 from 2028).You can’t normally cash in a pension until you reach pensionable age – and this may have risen even further by the time you come to retire.
Accessing your pension fund when you retire may also mean that you have to take part or all of your savings as income, rather than as a cash lump sum.
In addition, it’s worth taking into account that the level and basis of tax can change. Pension rules are frequently changed and so contribution limits or the tax treatment of pensions could change in the future. In addition, the value of tax relief and tax-efficient accounts depends on your personal circumstances.