Posted on: 21st March 2016
They say that if something isn’t broken, there’s no need to fix it…or words to that effect, anyway. Despite there having been widespread expectations that the Chancellor would outline hugereforms at this week’s Budget, it simply didn’t happen. Why? Well, most likely due to the fact that he was pummelled from all corners with complaints and objections, which resulted in him backing down.
Instead, we have the same rules on pension tax relief to work with – the result of a rare budget makeover which at the time was universally welcomed. So given that this is what we have, how does it work?
In the simplest terms, the way it works at the moment is that when you put money in a pension pot, tax relief makes it bigger. If you are a basic rate taxpayer, you put £80 into your pension, which magically becomes £100. This is because this saver’s income is taxed – all of it. They pay 20% in standard taxation, but as pension savings are tax free, this tax is actually paid out by the gov. If you are in the higher 40% tax bracket, you would pay £60 into your pension to find it with a balance of £100.
Does this basically mean free cash?
To a certain extent, yes – it does. What’s more, it also reinforces the importance of making sure pension contributions are started as early as possible. The reason being that even if you don’t pay a lot in, the long-term difference can be massive. There’s interest to be earned on top of all of this ‘free’ money, so letting it go to waste really isn’t a wise idea.
In a working example, a saver begins putting cash away at the age of 21, adding £100 per month to their pension pot for their whole career. With tax relief, this means £125 per month in the pot. And assuming the compound interest rate hovers around the 4% mark, at the time the saver reaches 55, they’d have a staggering £109,000 or so to play with. In the same example, if there were no tax relief contributions added to their monthly payments – so they just stayed at £100 – this would mean in the region of £87,000 by the age of 55.
Which is, however you look at it, a massive difference – £22,000!
Given the fact that higher-rate taxpayers get an extra 40% whacked onto their pension savings, the value of getting started and taking advantage early is even greater. It’s free money with free interest that could make the most incredible difference come.
For the time being, this is the system we have and the system that it likely to stick around for some time to come. It’s inevitable that reforms will creep into the equation sooner or later, but with a bit of luck the Chancellor will choose not to completely ruin things.
But that’s of course a prediction that none of us can rightly make – we’ll just have to ride it all out and see what happens!