Stakeholder pensions were introduced in 2001, followed by pension simplification in 2006 and then pension freedoms in 2015. This is not to mention the many other changes, including auto-enrolment, the abolition of contracting out, guaranteed minimum pension, retirement risk warnings, investment pathways and the ever-moving state pensions age.
Many of these came with attendant changes to the rules and regulations covering pensions taxation.
While there have been lots of pension tax changes since 2001 – the annual allowance(s) for instance – the actual mechanics of pension tax relief in a ‘relief at source’ scheme, such as personal pensions, has never changed:
- An amount, net of basic rate tax, is paid.
- The scheme reclaims that basic-rate tax and adds it to your pension.
- Your basic and higher tax threshold increase by the grossed-up contributions.
- You may be able to reclaim higher tax relief through self-assessment.
- 100 per cent of your relevant earnings is the maximum gross contribution you could pay.
It has been that way certainly for as long as I can remember.
Back on April 6 2001, some 21 years ago, stakeholder pensions were introduced, which had specific rules around cost charges and access.
Pension simplification swept away most of the pension tax changes we saw in 2001 so they have not seen their 21st birthday. However, there is one survivor in particular that has lived to reach this milestone and is, I believe, the only actual material change to how pension tax relief works in the 21st century.
There have always been, and there still are, limits on contributions. There were age-related percentages of your earnings you were allowed to contribute, you had carry back and carry forward (the old one not the annual allowance one), and 'basis year rules'.
Myriad rules and nuances, but one thing was common – you had to have relevant earnings. For the first time, from April 6 2001 you could pay in £3,600 gross regardless of relevant earnings, “… or £3,600 if higher” (according to HM Revenue & Customs).
This gave non-working partners, those having long career breaks, those unable to work for one reason or another or simply those whose with no relevant earnings, the ability to fund their pensions.
And this gave rise to my favourite pensions-related question: how much can you pay into your child’s pension? And the correct answer is 100 per cent of their relevant earnings or £3,600 if higher.
It was a good change and one that has and will continue to benefit those looking to make their money work harder for them.
To illustrate, let us look at three different scenarios where “or £3,600 if higher” has benefited non-earners.
If you have no earnings you can still have £3,600 in a pension and, since 6 April 2008, it only costs you £2,880 (it only cost £2,808 prior to that when the basic rate was 22 per cent). If you access that money when you are a basic rate tax payer you get £3,060 back – £180 gained. The basic principle is that the systematic moving of savings into the pension system, even though you have no relevant earnings, generates extra wealth, making savings last longer or money grow further which can only be a good thing.
Regular premium IHT planning
If a baby born on April 6 2001 had £3,600 paid into their pension every year since birth, say by their grandad, they would now have a healthy pension pot at their 21st birthday.
At 4 per cent growth and paid annual in advance, they would have around £120,000. Grandad will have been able to make those payments within his annual inheritance tax allowance, removing a touch under £60,000 from his estate and potentially saving around £24,000 in IHT.
And while I am sure the thought of his grandchild having access to a six-figure sum at the age of 21 may put a shiver down his spine, he is likely to be reassured that the pension tax rules prevent his grandchild accessing that amount of money until a sensible age. That is if you deem 57 to be a sensible age, of course.
A pensioner who got more than 500% tax relief
When you have a profit on an insurance bond gain that has built up over many years, the government acknowledges that it would be unfair to tax the whole gain in a single tax year. To reflect this you get taxed in a way that is broadly equivalent to what you would have paid if you had been taxed on your average gain each year.
Your average gain, is known as your 'top slice', and the more of it that is in your basic rate tax band the more top-slicing relief you get. If all your slice is in the basic rate tax band, your relief removes any liability to higher-rate tax on your bond gain. Those with onshore bond gains get a 20 per cent tax credit and so overall would have no tax to pay on their encashment.
You pay higher rates of tax based on the amount of the top-sliced gain (your average annual gain) that is over the basic and higher-rate threshold, which is currently £37,700 and £150,000 respectively.
Pension contributions increase your basic and higher-rate thresholds by the amount of the contribution. This means you can move some of your sliced gain from 45 per cent tax into 40 per cent tax or 40 per cent tax into 20 per cent tax. The more of the slice that is in a lower tax band the higher your top-slicing relief. Pension contributions get you tax relief but can also get your top-slicing relief.
This is exactly what happened to one retiree I heard of – let us call her Irene, a 72-year-old retiree, who was in receipt of £8,000 state pension income and £38,000 income from rental properties, who had held an onshore investment bond for 37 years, with a gain of £250,000.
It was easy enough to establish her tax liability for the year prior to any encashment. This was the income above the personal allowance multiplied by 20 per cent – in this case, a liability of £6,686.
Irene needed the money and was going ahead with the encashment and asked her adviser for an idea of the tax liability. If the bond were to be fully encashed, the client would lose her personal allowance (as you use the full gain to assess that), increasing her tax liabilities to £29,262. That is an increase of £22,576, which is not too bad on a £250,000 bond gain, and comes in at 9 per cent of the bond gain.
Irene’s 'slice' was £6,757, and only £2,487 of it was in the higher-rate tax band. This resulted in top-slicing relief of £38,898. Now that Irene had no relevant earnings, knowing that you could pay in £3,600 without needing to have any her adviser suggested just that.
This contribution raised Irene’s higher-rate threshold by £3,600 and meant the slice that was previously in the higher-rate tax band fell into the basic-rate band. Increasing her top-slicing relief by £18,222 to £57,120.
This meant the overall tax liability was reduced to £10,140 from £29,262, so a saving of £19,122 on the potential payment to HM Revenue & Customs.
When you add in the £720 relief at source in the pension from HMRC it is an overall tax saving of £19,842 from a £3,600 gross pension contribution. As a percentage of tax relief on the pension contribution, that is (£19,842/£3,600) x 100 = 551%.
Many people can benefit from this method of saving tax on bond gains, but before 2001 it would have been no use to Irene pre 2001 as she would not have had the relevant earnings to support her pension contribution that made all the difference to her tax bill.
So while there has been a multitude of changes to pensions in the 21st century, the basic fundamental mechanics of tax relief have remained untouched, other than the innovation of allowing pension funding without the earnings to support it.
Many people should be thankful that this change has made it to its 21st birthday and hope it sees many more.
So, it should be a happy birthday to “…or £3,600 or more”, especially from those who have, can have and in future will have a financial benefit because of it.
Les Cameron is head of technical at M&G Wealth
