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Your Money > Pensions Articles > Get the taxman...
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By Richard Evans
If you have been meaning to start a pension for ages but have never quite managed to get round to it, here is one fact that might shock you into action: the generosity of the taxman when you put money into a pension, when it's growing and when you take it out again means that this is probably the only legal way for money to go all the way from your gross salary, via investment growth and into your pocket to spend without attracting any tax whatsoever. Okay, strictly speaking this applies to just a quarter of your eventual pensions "pot", but the fact remains that you do not pay income tax on earnings that you put into a pension, you pay no tax as your pension increases in value as a result of investment growth, and you can take out 25 per cent of your eventual pot as tax-free cash, paying normal income tax on the income you receive from the rest. Let's look at each of these tax breaks in turn. Imagine you're a basic-rate taxpayer and you write a cheque for £7,800 and pay it into a personal pension. Without any effort on your part, the sum that actually goes into your pension is boosted to £10,000, because the taxman automatically rebates the income tax that you have paid. (In fact you get this rebate on sums of up to £3,600 even if you are a non-taxpayer.) Higher-rate taxpayers do even better. The same thing happens to their investment - £7,800 is boosted to £10,000 - but they can reclaim the higher-rate tax (in this case, £1,800) on their tax return. So for a net outlay from their bank account of £6,000, their pension gets £10,000. In other words, the investment you make receives a gigantic boost of 67 per cent, courtesy of the taxman. However, next month's cut in the basic rate of tax from 22 to 20 per cent means that the tax rebate will also fall. "For basic-rate taxpayers, the reduction in income tax means that their pensions will be around 3 per cent worse off, unless they increase their contributions to compensate," says Tom McPhail of Hargreaves Lansdown, the financial adviser. "For example, a £100 contribution today will be worth £128.20 in your pension. From 6 April it will be worth only £125 - a fall of 3.2 per cent." Because higher-rate taxpayers see the pension contributions they make from their own pocket given such a huge mark-up from tax relief, some commentators have suggested that it is best to delay paying money into your pension until you start paying the higher rate of tax. Instead, they say, you should build up your saving in Isas, where investment growth is also tax-free, and transfer the money to a pension when your earnings take you into the higher tax bracket, qualifying you for greater tax relief. "I disagree with this advice," says Mr McPhail. "For most people, the most efficient way to replace their salary with a retirement income is by making regular savings into their pension - this applies to both basic and higher-rate taxpayers." But he adds: "There may be a case for deferring a pension contribution and holding investments in an Isa if you know that you will be able to claim a higher tax rate in the foreseeable future, but this argument starts to break down the further into the future you go." The second major tax break given to pensions is that their investment gains are not taxable. So if, say, you put £100,000 into your pension and the company that runs it manages to double that sum by the time you retire, you will not pay any income or capital gains tax on the increase of £100,000. (The tax regime used to be even more generous, however; until 1997 pension schemes could reclaim a tax credit when they received income from dividends.) When you decide to take money out of your pension (which means between the ages of 50 and 75 at the moment, although the lower limit will change to 55 in 2010), you are allowed to take up to 25 per cent of its value as a tax-free lump sum. The rest of the money stays in your pension but is used to pay a taxable income for life called an annuity. "It almost invariably makes sense to draw the lump sum at retirement - even if you subsequently reinvest it in Isas and elsewhere," says Mr McPhail. "This is because all the income drawn from a pension is taxed, whereas by taking the lump sum you may be able to enjoy some or all of that capital entirely tax free." You also have the option to draw your lump sum in stages, and to treat it effectively as tax-free income direct from your pension fund, he adds. As far as the annuity is concerned, the taxman treats it like any other income, so you will have to pay tax on any amount above your personal allowance - although don't forget that these allowances are higher for those aged 65 and over. And whatever else you do, shop around for your annuity rather than just taking it from the company that managed your pension while you were paying into it. This simple exercise in consumer power could see your retirement income boosted by as much as 20 per cent. Of course, making the most of the tax breaks is not the only factor behind getting the right pension. You also need to consider the type of scheme that's best for you and perhaps the type of assets you want your money invested in. If your employer offers a scheme and contributes to it, it's normally a good idea to join - not doing so means you're effectively choosing to take a cut in salary. When it comes to personal pensions - ones that you arrange yourself - the choice is between stakeholders and Sipps (self-invested personal pensions). Stakeholders are simpler - they offer a relatively restricted range of investments - and their charges are capped by the Government. Sipps allow you to invest in a much greater range of assets and funds, and are generally more suited to people who want to take control of their investments. You can usually transfer your old occupational and personal pensions into a Sipp, allowing you to consolidate all your retirement savings under one roof, which makes switching assets much easier. With long-term savings such as pensions, the advice is usually to put your money in shares rather than "safer" assets such as cash and bonds. "All available evidence tells us that an equity-based investment strategy yields the best results in the long term," says Mr McPhail. "For anyone with 10 years or more to go until retirement, the default position should be to have the bulk of their pension invested in a mixture of UK and overseas shares. How conservative or speculative your strategy is should be determined by how long you have to go." Still not convinced that you should start your pension today? Mr McPhail says: "It is impossible to overstate the importance of making adequate savings for retirement. The state pension and welfare system will probably keep you from starving, but it won't give you any kind of quality of life at all. If you want to avoid an impoverished, and probably fairly miserable, retirement then it is essential to plan ahead. "And don't rely on your house to bail you out. It is simply unrealistic to expect to extract sufficient capital from your home at retirement to satisfy your income needs. There is no substitute for the simple discipline of paying into a pension month in, month out, and from as early an age as possible." 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