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What makes people buy a pension?

Author Image Les Cameron Head of Technical
8 minutes read
Last updated on 1st Jul 2020

Overview

Over the last few weeks and days we have heard more about the need for a reduction in government spending and/or an increase in taxation towards the end of this year.

Inevitably this will lead to speculation that pension tax relief could be amended in some way.

A flat rate has been mooted before, at an amount above basic rate relief, and this increased incentive could see an increase in pension savings.

But does tax relief incentivise? Does the language used, (contributions, adjusted net incomes, taxable income, relief at source, net pay and extension of tax bands) turn people off?

When I think of my weekly supermarket shop I get drawn to a %  extra free, 2 for 1 and get now whilst stocks last. You know what I mean.

And these phrases could be used to describe pension tax relief, as you can see from the effective rates of relief below.

We’ll probably never get away with using “supermarket” language when promoting pension saving but we can get away with avoiding jargon.

Surely the  average person in the street just wants to spend some money to meet a need of some sort. Spending, or cost benefit analysis, is fairly straightforward:

  1. How much do I spend?
  2. What do I get back?
  3. What’s the return?
  4. How long do I need to wait for it?
Tax status Questions Return Over
Entry (tax relief) Exit (tax on balance after PCLS)  How much did i spend?  How much did i get back  What's the return?  5 years  10 years 
20%  0%  £80.00  £100.00  25.00%  4.56%  2.26% 
20%  20%  £80.00  £85.00  6.25%  1.22%  0.61% 
30%  0%  £70.00  £100.00  42.86%  7.39%  3.63% 
30%  20%  £70.00  £85.00  21.43%  3.96%  1.96% 
40%  0%  £60.00  £100.00  66.67%  10.76%  5.24% 
40%  20%  £60.00  £85.00  41.67%  7.21%  3.54% 
40%  40%  £60.00  £70.00  16.67%  3.13%  1.55% 
45%  20%  £55.00  £85.00  54.55%  9.10%  4.45% 
45%  40%  £55.00  £70.00  27.27%  4.94%  2.44% 
45%  45%  £55.00  £66.00  20.45%  3.79%  1.88% 
60%  20%  £40.00  £85.00  112.50%  16.27%  7.83% 
60%  40%  £40.00  £70.00  75.00%  11.84%  5.76% 
60%  45%  £40.00  £66.25 65.63%  10.62%  5.18% 
70%  20%  £30.00  £85.00  183.33%  23.16%  10.98% 
70%  40%  £30.00  £70.00  133.33%  18.47%  8.84% 
70%  45%  £30.00  £66.25  120.83%  17.17%  8.24% 

For a basic rate taxpayer making a pension contribution the answer to the first question would be £80, the second £85 (tax relief tops up to £100 less 20% tax on the amount after PCLS) and the third 6.25%. Question four? Whatever really but let’s say 5 years.

So that’s a 6.25% return averaging out at just over 1.22% over 5 years and 0.61% over ten years. Not the highest return. But what if you’re retiring soon? Would you wait a short period for a 6.25% return?

Should tax relief not just be called “free return”? Or 25% extra free, but that’s pre tax!

And therefore the higher the relief you can get on your pension contribution the more likely you are to get a good level of “free return”. If tax relief exceeds 50% we’re buying one and getting one free!  If your tax on exit is lower than your tax on entry could that be a loyalty reward?

The table above has some strange tax relief numbers though. Most will think of tax relief at either 20% 40% or 45 % but you do get other numbers. 

You can only make pension contributions up to your relevant earnings (£3,600 if higher). But the actual effective rate of tax relief depends on what type of income is receiving higher relief and whether you are getting to exit or mitigate any tax traps.

I’ll just run with UK rates, no need to complicate matters with Scottish rates – the principles are the same in Scotland but with higher tax your pension is cheapest in the UK!  Other than the “net pay anomaly” relief at source and net pay contributions broadly produce the same results.

With relief at source schemes, tax relief is granted by allowing a deduction based on basic rate relief from your contribution. The higher and additional rate threshold are then increased in tandem by the gross amount.  For example, if you put in £8,000 it is grossed up to £10,000 and your higher rate threshold becomes £60,000 and additional rate tax starts at £160,000.

Tax relief is dictated by what type of income or gains moves into a lower band.

Also, pension contributions reduce your adjusted net income.  As this dictates the impact of any tax traps, there may be relief gained in this way. You can also get relief at a higher amount than the actual rate of tax on the income you’re relieving.

The graph below shows the potential rates of tax relief.

Or generating free return. Or allowing  us to claim <<insert an appropriate supermarket style promo here>>. Where do we find it!

The “standard rates”

Where the tax band extension results in earned income, such as salary or bonus, being moved from higher rates to lower rates then relief is as expected at 40% or 45%.

So, someone has £10,000 in the higher rate tax band. They pay an £8,000 contribution. 20%, £2,000, relief at source is added.  As the higher rate threshold is extended by the £10,000 this excess is now taxed at 20% instead of 40% - another £2,000 saving. The £10,000 gross contribution has generated £4,00 tax relief i.e. 40%.

Free return? Investment boost? 25% extra free? 5 for the price of 4?

High earner trap

Almost every individual subject to UK income tax is entitled to a personal allowance but some find when computing their tax it has been lost. This occurs where Adjusted Net Income in a tax year is greater than £100,000 and means the loss of £1 of personal allowance for every £2 of excess (over £100,000).

This creates an effective tax rate of 60% - far higher than the 40% a higher rate taxpayer may, understandably, expect to be charged (40% tax on the £2 plus 40% tax on the lost £1 = £1.20/£2). At income over £125,000 in 2020/21 all the personal allowance is lost.

So,  someone with £10,000 in excess of the £100,000 limit, will see an effective tax rate of 60%on that excess, i.e. normal higher rate tax of £4,000 plus £2,000 due to the reduced allowance.  A pension contribution of £10,000 will currently get all of that back – effective 60% relief.

Your initial spend would be £4,000.  After PCLS you’d end up with an outlay of £1,500 for a pension pot of £7,500.  Five for the price of one anyone? Better than half price?  These deals cannot be beaten?

Child benefit

The high income child benefit tax charge has been here since January 2013.

This charge rests on the person with the highest (adjusted net) income in a household where child benefit is claimed. This might not be the same person who claims the child benefit of course.

The charge depends on the number of children and how much over the threshold of £50,000 the ANI is.  The charge is levied at 1% of the total benefit for every £100 over the threshold until the charge becomes 100% at £60,000. The amount depends on the number of children with a larger number causing a higher charge due to greater child benefit.

So, someone with 2 children and adjusted net income of £60,000 will see £4,000 tax on their earnings above the £50,000 threshold, and the loss of £1,820 child benefit -  an effective rate of tax 58.20%.  A pension contribution of £10,000 gross will see £4,000 tax relief as normal plus no need to pay the £1,820 charge – £5,820 or 58.20% relief.

The other rates are in the graph above. And remember basic rate taxpayers go straight into this trap as the higher rate threshold is £50,000.

If you’re in the child benefit trap your tax relief is in excess of 50%, just a better than half price pension? Or you qualify for the 2 for 1 promo!

Dividends

Dividends are not relevant earnings so cannot support a pension contribution. In many cases someone will have relevant earnings along with dividends. It’s not unusual for someone to have earned income which is either tax free or taxed at basic rate leaving the dividends in the higher tax bands.

This makes for interesting tax relief. Pension tax relief is 20% basic rate at source, but the basic rate on dividends is 7.5%.  We then add to this the difference between the higher rates and basic rates on the income that being relieved. This will be 25% or 30.6%.

This makes the effective rate of relief on dividends higher than the actual higher rates of dividend tax at 45% or 50.6%.

Might people like getting more tax relief than the amount of tax payable?

Higher rate Capital Gains Tax (CGT)

This one is like dividends above – the rate of tax relief is higher than the rate of capital gains tax. 

Again the capital gain is not relevant earnings but there will usually be contribution supporting income.

Where there is a taxable gain it is added to the top of all your taxable income (if there’s a bond gain you only use the slice). That part of any gain which falls within the basic rate tax band is taxed at 10% the rest is taxed at 20% (or 18% and 28% where the gain relates to residential property). 

As a pension contribution extends the basic rate band this can pull gains taxed in the higher band into the lower band. Pensions still receive the 20% basic rate relief even though the basic rate of CGT is only 10%. Added to the 10% CGT saving, that gives effective relief of 30% for people who probably view themselves as basic rate taxpayers. In reality, the capital gain has made them higher rate taxpayers but they will get more tax relief than the increased CGT liability they would otherwise have had.

Free money…?

Investment bond gains

The tax mechanics of investment bond gains are similar to capital gains. The ‘top sliced’ gain is added to income to determine the rate of tax payable. The main difference is that, with bonds, the resultant tax applies to the total gain – not only the slice. The benefits of pension contributions here are most apparent when income is around the 40% or 45% tax thresholds. The pension contribution effectively moves the ‘slice’ of gain from higher to basic (or additional to higher) rate tax, but with the result that higher/ additional rate tax is saved on the whole gain. This approach can result in significant levels of tax relief being achieved.

So, for simplicity, let’s take a £50,000 onshore bond gain with a £5,000 slice and (wholly in the interest of simplicity) their other income uses up all the basic rate band and savings allowances. This means the slice is sitting wholly in the higher rate tax band, which means £10,000 tax payable. A £5,000 contribution would move the slice into basic rate generating full top slicing relief. The tax saving would be double the pension contribution.  

If you write a cheque and your net income rises is that free money? Or maybe it’s “cashback”!

Pensions might be bought more if the language used was a little more on the supermarket side of things.

Are we entering “buy now while stocks last”?

"Prudential" is a trading name of Prudential Distribution Limited. Prudential Distribution Limited is registered in Scotland. Registered Office at Craigforth, Stirling FK9 4UE. Registered number SC212640. Authorised and regulated by the Financial Conduct Authority. Prudential Distribution Limited is part of the same corporate group as the Prudential Assurance Company. The Prudential Assurance Company and Prudential Distribution Limited are direct/indirect subsidiaries of M&G plc, a company incorporated in the United Kingdom. These companies are not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America or Prudential plc, an international group incorporated in the United Kingdom.