Tom McPhail, of Hargreaves Lansdown, explains how to make the best of your pension in light of recent pension rule changes.
What is the point of pensions, and how can we make best use of them? The obvious answer is to save for retirement, and to save as much as you can. But within that broad generalisation, the goalposts keep moving, and recent changes to the system (some of which are still in train) presents both opportunities and challenges.
LTAs, AAs and ISAs
The Lifetime Allowance (LTA) and Annual Allowance (AA) have both been subject to drastic reductions in recent years. After being set and then increased to improbably generous levels between 2006 and 2010, the subsequent cuts to the AA and to the LTA down to £1 million in particular, has left many middle to senior employees in their 40s and 50s wondering at what point they should opt out of their workplace pension.
After all, what’s the purpose in paying your and your employer’s contributions into a pension that’s going to be taxed at 55% when you come to draw the money out?
Increasing numbers are likely to start using workplace ISAs as an alternative. I do feel the LTA is a policy measure that has outlived its usefulness; hopefully there will be scope to abolish it as part of the current Treasury pension tax review.
Those who pay 45% tax have now been served notice that from next April they will start to see their AA cut to just£10,000 a year for anyone earning over £210,000. This too feels like an ill-judged and short-termist policy, which can hopefully be reversed as part of the tax review.
In the meantime, for these top earners in particular, and in fact for anyone paying 40% tax, the higher rate tax-relief tap looks like it is about to be turned off, so it absolutely makes sense to fill your buckets this year, if you can.
As if to encourage the exploitation of this last gasp opportunity, the Treasury has also very helpfully reset the allowance for the remainder of the current tax year, which means that unless you have already paid over £40,000 into a pension in the current tax year before 9 July, you can pay in up to another £40,000 before the end of the current year (5 April 2016). You can also carry forward unused relief from the past 3 years, meaning a one-off, and probably final, chance to pay a six-figure sum into your pension and enjoy full marginal rate tax-relief. But proceed with caution, as the details, including pension input periods, are complicated.
The Treasury tax review is asking fundamental questions about our pension system. The basic principle of incentivising individuals (and their employers) to defer consumption, and to channel income into reserve accounts to pay for old age, still holds true. But just about everything else is up for grabs. My best guess is the Treasury will move to a flat-rate incentive system, probably around 30%, with a lower annual allowance and, hopefully, coupled with the abolition of the LTA. We’ll find out later this year.
Pensions and inheritance planning
In the meantime, recent changes to the death benefits rules mean that pensions can now be legitimately regarded as an inheritance planning vehicle. For wealthier individuals, passing that wealth on through the pension system will be more tax-efficient than many other options. This in turn means that it makes sense to get as close to the LTA as possible and also, for some at least, to then run down other assets before the pension pot.
If you are sufficiently well-organised to die before age 75, the pension pot passes to beneficiaries entirely tax free. Even on death after age 75, the recipients are only liable to income tax at the time when they draw money from the pension pot. Philosophically, this seems to shift the relationship between the individual and their pension savings away from the state and broader society (through the tax system), and on to their immediate circle of family (and possibly friends, too).
Whatever the politics of this change, my one worry is that it is too generous. Past experience suggests that tax concessions that look too good to be true tend not to last very long.
About the author
Tom McPhail is head of pensions research at Hargreaves Lansdown. He's one of the foremost pensions commentators in the UK and has been involved in numerous government consultations on pension reform in recent years. Tom is also a governor of the independent charity the Pensions Policy Institute.