What would you get from the Government?

STATE PENSION

The Age related Tax Allowance might be used up by the State Pension, State Second Pension and National Pension Savings Scheme

By 2020 Men and women pension age will be equal. There will be a gradual rise in the state pension age, to 66 by 2030, 67 by 2040, and 68 by 2050. You can obtain an estimate of pension age from HMRC's website.

By 2010 you will only require 30yrs of National Insurance contributions to qualify for State Pension. Also, there are allowances for those that have been looking after children.

HMRC's website indicates the Income Tax Allowances for 2009/10:

o 65-75 have £9,490
o 75+ have £9,640

This is the amount the Government will allow you to earn tax free per year. Income above this is taxed.

The Government’s Pension Service website indicates that the state pension for 2009 is

o £95.25 p/w or £4,953 p/yr

The Pension Service website also allows you to produce a forecasted State Pension, including the SERPS/State Second Pension element. For someone who has paid full National Insurance contributions and has not 'contracted out', this element will total in the region of:

o £63.80 p/w or £3,317 p/yr

So the State Pension and SERPS/State Second Pension will total in the region of £8000 per year

This leaves a tax free allowance of: £9,490 - £4953 - £3317 = £1220 per year

NATIONAL PENSION SAVINGS SCHEME

Under NPSS, also called Personal Accounts:

o Employers will have to contribute 3% (earnings will be banded, approximately £5,000-£33,000)

o Employees will pay in 4% of their salary

o The Government will contribute 1% in tax relief.

All UK employees will automatically be enrolled - unless they are members of an occupational pension scheme which has contribution rates above those of the NPSS. But employees will be able to opt out

The National Pension Savings Scheme might well eat up more of the tax free allowance above

How is income from a Personal Pension treated?

You receive a tax rebate from the Government for any money put into a pension. However, this is TAX DEFFERED, not tax-free. If your income is over the tax-free allowances mentioned above, you will pay tax on that income in retirement.

Importantly above we have worked out that after you have received the State Pension, you only have £1220 of your tax-free allowance left. Therefore any Personal Pension, Savings income or any other form of income above £1220 will be taxed.

Therefore, the majority of the money you have paid into a Personal Pension, that received that generous tax rebate from the Government, will be clawed back by them as you draw the pension. Tax is said to be DEFFERED until you take the pension

Nil rate Income Tax payers will get their contributions grossed up. However they are limited to 100% salary or a yearly limit of around £3600. Again, they might well be taxed when drawing this pension though. Therefore, basic rate taxpayers will save basic rate tax on their pension contributions, but pay basic rate on drawdown. No benefit.

25% TAX FREE ALLOWANCE

The Government allows you to take 25% of your Personal Pension pot tax-free on retirement. However this only allows 25% of the fund to be tax free, the remaining 75% is likely to be taxed as with the State Pension, it puts you outside of your tax-free allowance.

So of the entire 22%/40% Income Tax rebated to the Personal Pension fund, you will only receive 25% of this. This equates a tax saving of 5.5% (22% x 25%) for lower rate taxpayers or 10% (40% x 25%) for higher tax rate payers.

If you are paying higher rate tax now you will save higher rate tax on your pension contributions but possibly likely to only pay lower rate tax on drawdown. However, note that the of the 40% higher rate relief, 22% is given back into the fund and the remaining 18% is given as a Tax Refund on your Self Assessment with no requirement to add it to a pension. Therefore the 18% tax relief can be invested in an ISA, without the pension restrictions.

Note: Higher Rate Relief is only equivalent to the top slice of your income that is taxed at 40% and not the whole income – therefore only the equivalent pension payment will get higher rate tax relief.

AGE ALLOWANCES

As you can see above, from 65 the Government allows an Age Allowance - an increased tax-free allowance.

However taxable income in retirement above an income limit for age-related allowances (£22,900 in 2009/10 - for current rates see HMRC's website) increases your tax burden. For every £2 above this limit, your age allowance is reduced by £1, until the basic rate allowance is reached (you'll always get the basic allowance, whatever the level of your income).

Income from ISAs does not count towards your taxable income, however savings account interest does.

So if, for example, you're 66 and have an income of £23,500 (£600 over the limit) your age-related allowance of £9,490 would reduce by £300 to £9,190

Therefore, you should target your Personal Pension income not to exceed limit for age-related allowances.

So what amount should I put in a Personal Pension?

If you have any tax allowance left after receiving the State Pension (see above), a Personal Pension can be used to fill this gap. This will allow you to save the full 22%/40% tax.

Next use the Personal Pension to provide an income between the tax-free limit and the income limit for age-related allowances. You will be taxed on this at 22%, however the 5.5% of this will be tax free due to the 25% lump sum payment from a pension.

So approximately per year:

£8,000 State Pension and SERPS/State Second Pension

£15,000 Personal Pension

Therefore, you can crudely estimate the amount per year you need to contribute to a Personal Pension:

Estimate your retirement age

Estimate age of death/no longer requiring retirement income

Times the number of years of retirement by £15,000 - this is the Personal Pension pot target

Divide your Personal Pension pot target by the number of years till retirement - this is how much per year you will need to contribute to your Personal Pension

What if I want an income above the income limit for age-related allowances?

For income above this, you are better saving into an ISA. However some people are confused that the tax relief you receive when you initially contribute to a pension doesn't cause the pension fund to grow at a greater rate than an ISA. You can see from the table below that this is not the case:

The Pension fund will initially have 22% (or 40% if a higher rate tax payer) more added to it through tax relief. However, as tax is a percentage, even if the fund grows more, it just means a larger amount is taken off at the end. The fund grows more, but so does the amount taken off at the end in tax. (this is provided you pay tax when taking pension, however the above discussion shows this is more than likely)

The result is that ISA's are as equally a tax efficient investment as Pensions.

Below are some of the ISA vs. Pension considerations:

Above the income limit for age-related allowances, pensions lose their tax efficiency. The age allowance is reduced and income is taxed negating the tax deferral benefit. It is then better to use an ISA as they have allot more flexibility than a pension. Also ISA income doesn’t count towards reducing the Tax Free Allowance.

You can invest in a pension right upto the year before retirement upto the lifetime allowance of over a million pounds. Therefore you could invest in an ISA, negating pension restrictions and then move it all to a pension to benefit from the 25% tax-free and possible tax allowance benefits. You can save into an ISA while you are paying lower rate tax, then move the whole lot to a pension in a year when you are paying higher rate tax to get the full pension benefit.

Tax rates could change from now to retirement. If they go up you could be worse off (ie save 22% but have to pay 26%) and if they go down you could be better off (save 22% and pay 20%)