| Money Talk By Tom McPhail Hargreaves Lansdown |
Most of us need to put money aside for our retirement.
And there are a variety of ways we can do that: buy residential property, invest in an Isa, stash cash under a mattress and so on.
But the reason that a pension is a fundamental part of the solution for most people is because of the tax breaks the government gives you when you invest in one.
Here, then, is a brief explanation of how it works.
Tax rates
The amount of tax relief you get depends broadly on what rate of income tax you pay.
The one exception to this is non-taxpayers, such as children, who can invest up to £3,600 a year and benefit from basic rate tax relief on their investment, even though they don't pay tax.
Pension contributions are paid net of basic rate tax (currently 22%).
In practice, this means that if you want to make an investment of, say, £100 in your pension, then you actually pay in £78 - which is £100 less the £22 tax relief.
Your pension company then claims the tax relief from the government and adds the £22 to your pension, giving a gross contribution of £100; this happens automatically.
Confusingly, this actually means that your return on your investment is 28.2%, because you have received a £22 gain (the tax relief) for an initial outlay of £78.
Higher rates
For higher rate taxpayers, there is the additional benefit of being able to claim back from the government the difference between the basic rate of 22% and the higher tax rate of 40% - another 18%.
The higher rate relief is calculated on the gross contribution.
So in the above example, the additional relief would be £18.
Nominally therefore, the tax relief is 40%, but because of the way it is calculated, an initial outlay of £78 produces total tax relief of £40 - which is a return of 51%.
You need to claim this higher rate relief from HMRC, either by writing to them or by claiming it on your tax return.
New pension scheme
The government plans to introduce a new pension scheme in 2012, currently called Personal Accounts, for anyone not already in a pension.
The same tax relief system outlined above will apply to contributions made to Personal Accounts when they are up and running.
Now because this is perhaps not quite complicated enough, the system of tax relief works differently for many employer-sponsored company pensions, such as final salary schemes.
Here, your pension contributions are deducted from your income before your tax liability is calculated every month.
So for example, if you earn £1,000 this month, and you are paying £100 into your company pension, then you will only have to pay tax on £900 of your income.
This achieves the same outcome in terms of benefit you enjoy - it just gets there by a different route.
Incentive to save?
Interestingly, the system is weighted heavily in favour of higher rate taxpayers.
Over half of the relief given on individuals' contributions to their pensions goes to higher rate taxpayers, even though they are outnumbered four- or five-to-one by basic rate taxpayers, in terms of numbers of people contributing to a pension.
There are two schools of thought on this issue.
One is that tax relief is granted to incentivise deferred consumption, and in order for the system to work, it has to be granted at the same rate of tax as an individual pays on his or her income.
Otherwise it might be more rational to spend the money now, rather than saving it for later.
So the system should be allowed to continue as it is.
The alternative view of this issue is that the government has limited resources, and so it makes sense to target the tax relief at the people that it most needs to encourage to save for retirement, and that means low to middle-income earners.
So the tax relief system should be redesigned to be weighted more in favour of basic rate taxpayers.
In any event, we will all lose out from 6 April 2008, because on that date the basic rate of income tax will drop from 22% to 20%, and that means that we will all receive a little less tax relief on our pension contributions.
So if you are thinking of investing for your retirement, and particularly if it is a lump sum, then it makes sense to do it before the end of the tax year.
The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.
