Pensions – crucial, but curtailed
Pensions should play an important part in everyone’s long-term financial planning for a number of reasons. These include making the most of any employer’s contributions and the fact that money is securely tied up for your future. Uniquely, your contributions are typically also tax-free on the way in, making it a very tax efficient way to save.
However, pensions do have their limits, especially for savers with big aspirations for their retirement. There are two important thresholds to bear in mind, when planning your long-term savings:
- Lifetime allowance – If your pension pot is valued above £1.03 million, you usually have to pay tax when you take money above this threshold from your pot. The tax rate on savings above your lifetime allowance will be either 55%, if you take it as a lump sum, or 25% otherwise.
- Annual allowance – If you contribute more than a given amount to your pension pot in any year, you usually have to pay tax on the extra amount. This cap is currently £40,000 a year for most people, but is lower for higher earners. The annual allowance is reduced by £1 for every £2 earned above £150,000. For anyone earning £210,000 or more, the allowance is £10,000 a year.
These allowances may sound higher than they are, considering that both include your employer’s contributions. Remember that it is the value of your pension pot – not the amount that you contributed – that counts towards your lifetime allowance, and so investment growth over time could push you over this threshold.
Also bear in mind that all of your pension income – including from a state pension – is normally taxed like other income. This means that even in retirement, annual earnings above £46,350 are subject to the higher rate of tax – currently 40%.
Looking beyond pensions
Given the limits on how much you can put in and take out of your pension without paying potentially significant amounts of tax, it might be worth considering how to complement it with other savings and investments.
An important tool is the individual savings account, or ISA, which can be used to hold any combination of cash savings and investments in stocks and shares, as well as peer-to-peer loans. In the current tax year, up to £20,000 can be contributed to your ISA.
The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.
While you will have paid tax on money that you save or invest into an ISA, unlike a pension any income that you receive and any capital gains from a rise in the value of your investments will be free from personal taxation, irrespective of any other earnings you have.
It’s important to remember that ISA tax rules may change in the future, and the tax advantages of investing through an ISA will also depend on your personal circumstances.
Recent changes to pension rules mean you can access up to 25% of your pension pots as a tax-free lump sum from the age of 55.
While you can choose how to spend your Pension Commencement Lump Sum – better known as tax-free cash – you should remember that any spending now is likely to reduce your potential income in retirement.
It may be prudent, depending on your circumstances, to consider using this lump sum to pay off any debts or perhaps reinvest it for your future. If you choose to save or invest through an ISA, remember that any gains or income will themselves be tax-free – unlike in a pension.
In the current climate, looking beyond pensions to put your money to work could give you more choices in retirement. The right solution will be unique to your goals and needs, but there are a number of investment strategies that could help grow your money in time for life after work.
As ever, if you are at all unsure about the suitability of any approach or investment, you should speak to your financial adviser. The views expressed in this document should not be taken as a recommendation, advice or forecast.