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Age-Concern-LogoThe Pensions Policy Institute (PPI) has just released a report that has been part-sponsored by Age Concern UK and the TUC, which shows that tax relief on pension contributions does very little to encourage saving, particularly amongst the lower paid and middle earners.

The main points highlighted by the report are:-

1.       The current raft of tax incentives, the biggest of which being tax relief on contributions, has done little to increase the level of savings for pensions.
2.       There is clear evidence that, despite massive publicity from the Government and pension providers, there still remains a remarkably low level of public understanding about how the system works.
3.       There is an increasing savings gap between how much people save, and how much they’re likely to need in retirement.
4.       Despite the advantages to pension savers of tax relief, tax payers on basic rate have received only 30% of the total tax relief, despite making 50% of overall pension contributions.

How Tax Relief Works

The Government encourages you to save for your retirement, by making sure that you don’t pay tax twice on the same income. So when you make a pension contribution the government will top it up with tax relief to increase your pension pot.

For basic rate taxpayer, tax relief is 20%: thus a monthly pension contribution of say £200 will be supplemented with a government contribution of £50, resulting in a total annual contribution of £3,000.

It gets even better for Higher rate taxpayers as they benefit from 40% tax relief, so the same £200 monthly pension contribution will be supplemented with a government contribution of £133.40, resulting in a total annual contribution of £4,000.

Additionally, Higher-rate taxpayers get an additional benefit from the reliefs, as all or a significant part of their income in retirement will be taxed at the basic-rate of 20% This is as a result of them receiving 40% tax relief on pension contributions but only paying 20% tax when drawing their pension income in retirement.

To encourage you further, when you come to retire, the government provides an additional tax incentive and allows you to receive a lump sum of up to 25% of your pension pots’ total value tax-free. The PPI estimate that based on current levels of contributions, when added together, the tax reliefs for pension savers cost the government a whopping £35billion a year.

Is it still worthwhile saving for your retirement?

It a recent Blog, published on 19th July (Pension Income falls by 30% in 3 years), I  informed you that recently published figures from the Office for National Statistics, show that in the last three years the cost of buying an annuity has risen by nearly 30%, compared to what you would have achieved in 2009, so should you bother?

The PPI’s report makes it clear that pensions contributions are still highly advantageous, extremely tax-efficient long-term savings products, whatever your tax position. It gives the example of on scenario where a £1,000 annual contribution invested each year between the ages 40 and 65, both basic and higher-rate taxpayers would receive significantly more in tax incentives from a pension than putting your money in any other secure long-term savings scheme, such as ISA’s.

So, what can be done to encourage more pension saving? One suggestion from the PPI is a flat rate incentive, where all savers benefit from 30% tax relief on contributions regardless of their tax bracket, which the PPI state could be achieved without increasing the overall £35billion cost to the Government.

I really like this suggestion as firstly, it will give the lower paid and middle earners the incentive of increasing their current low level of contributions with the financial carrot of an extra 10% contribution from the Government. This extra contribution should more than outweigh the recent rise in the cost of buying an annuity, which is the main reason for the fall-off in contributions from this group.

And secondly, historical evidence shows that it is highly unlikely to reduce contributions from higher-rate taxpayers, as they usually more financially astute and realise the tax advantages are still significant, if a little lower than before. Also in retirement they are likely to still pay a lower rate of tax than the 30% tax relief on contributions.

David Jones is the Senior Partner and Founder of Morgan Jones & Company. Born in Liverpool and a graduate of Liverpool Collegiate Grammar School, David spent twenty years working for the Customs & Excise in London then Shrewsbury before starting his own business. David’s depth of knowledge of the UK tax system and his ability to communicate this learning has seen Morgan Jones & Company grow into Shropshire’s most respected Accountancy Practice. Email David
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