Getting to grips with pension tax benefits…
As anyone who has studied ethics at the advanced level will know, investment advice is one of the three restricted areas for accountants, so this article isn’t meant to replace investment advice from a suitably qualified independent Financial Advisor, however, there are worse things to spend your money on than a pension; but there are so many options available that it can be a bit overwhelming.
I don’t want to tell you which pension you should go for, but rather explain how the tax benefit applies between the two main types of pension; occupational pensions and private pensions.
The government often use tax policy to influence people’s behaviour; think of tax on cigarettes and alcohol. These are examples of the government trying to dissuade people from doing something. However, governments would like to encourage people to save for their retirement, so the public purse doesn’t have to look after them. Therefore, you will get a tax benefit when you put money into a pension.
There are two ways this works depending on the type of pension.
If you have an occupational pension, which is run by your employer, your employer will take money from your wages and put it into your pension plan. However, your employer will take this from you before they calculate the tax on your wages. Let’s look at a simple example of a basic rate tax payer, who pays tax at 20%, who pays £100 into their pension every month. Their employer will take £100 from the employee and put this into the employee’s pension plan. However, they will take it off the employee before the employer calculates the employee’s tax. If the employee had not paid £100 into the pension, they would have been taxed at 20% on their income, and they would have only received £80 in their net pay from this £100. So if the employee pays £100 into their pension plan, the actual cost to them is only the £80 they would have otherwise received, yet £100 goes into their pension plan.
Private pension plans work in a different way. You pay money into your personal pension plan net of a tax credit. Basically you pay the amount into your pension plan, and HMRC top it up to the same amount as it would be if it was an occupational pension, with a tax credit. For example, you pay £80 into your pension plan, and HMRC will put in an extra £20. This leaves £100 in your pension plan, but it only costs the tax payer £80. A different method but with the same result.
Higher rate taxpayers
If someone is a higher rate tax payer it gets a little more complicated. If a higher rate tax payer, who pays tax at 40%, pays £100 into their pension plan, again, this will be deducted before the calculation of tax. If they didn’t put this money into their pension plan, they would only have received £60 (after the deduction of 40% tax) into their pay packet. So if they put £100 into a pension, it is only costing them £60 out of their pocket. With an occupational pension the tax credit is given at source, so the tax relief is always at the correct rate.
It is a little bit more complicated with a private pension though. Your pension provider doesn’t know what rate of tax you pay, so they always ask HMRC for the 20% tax credit. So if you are a higher rate tax payer and pay £80 into your pension plan, you will only get £20 added into your pension by HMRC. So at first glance, it looks like it is better to have an occupational pension rather than a private pension if you are a higher rate tax payer.
To make things fair, HMRC will extend your basic rate band by the gross amount of your pension contribution. So taking our example above, if the tax payer pays £80 into their pension, HRMC will add £20 to it, the gross amount will be £100. So their basic rate band will be extended by £100. This means that for £100 of income they are paying 20% tax rather than the 40% tax they otherwise would have paid. So the tax payer will be paying £20 less tax, based on paying 20% on £100, rather than 40% of £100. Therefore, at the end of the day, the cost of putting £100 into their personal pension plan will be £60 for a higher rate tax payer. They will be putting £80 into their pension plan, but then their overall tax bill be £20 less, so the net cost to the tax payer will be £60, the same as if it was an occupational plan.
Written by Nick Craggs, AAT Distance Learning Director at First Intuition