My pension history
Some time ago I had not been much of a pension proponent. I had not decided yet where in the world should my place to settle down be. Additionally I had a general mistrust to a pension concept - my country of birth government just made a run on the pension pot. We were also scrambling to put together a good enough deposit for our first step of the property ladder. Even being a higher rate taxpayer had not really convinced me to do any personal contributions. As a result at age 30 my pension pot was absolutely empty.
However my approach to pensions changed a few years ago from “no thank you” to “should have thought about it earlier!”. That was triggered by a set of facts:
- change in a perspective on how to think about pensions
- becoming a (mortgaged) homeowner reduced our need to hold onto a cash
- decision that United Kingdom is actually a country that we want to settle in for good
- a stark realisation of how much money you are giving away in taxes especially when hitting reduced personal allowance income level (60%!)
Private pensions in a nutshell
Pensions are usually not one of the most interesting topics. However their understanding is critical as they can be a very effective tool in shortening years that you need to work before reaching the desired level of retirement funds.
Usually as an employee your pension is your workplace pension. They mostly don’t allow for a higher level of control and are tagged with not negligible management fees. The better alternative is self-invested personal pension (SIPP). It allows you to invest in pretty much all the same instruments that your standard brokerage account. If you are a high earner and above you can effectively save a huge chunk of your income from becoming a tax. Even better, your investments can grow tax free.
There are well known downsides. First is that you can access your money only at 55. That might get increased to 57 in a decade or so (at that will be further extended to be 10 years less than the start of a state pension). The second one is that tax on your income is just postponed to the moment when you start to withdraw your pension money. Worth noting is also a lifetime allowance limit that is currently £1.055 mln. After your pension pot reaches this level (good problem to have!) withdrawals are penalised with 55% tax! I will create a separate blog post and calculator that helps to estimate your pension investments with this limit in mind.
On a bright side, at the moment upon reaching your retirement age, you can take 25% of the pot tax free. Also if you plan your financial independence carefully you should be able to maximise tax efficiency of your withdrawals by using annual personal allowance.
In short private pensions is a type of tax optimised investment account that offers a considerable boost to your contributions while delaying access to your money. It offers an opportunity to increase your net worth substantially by sacrificing some of your take home pay today.
How pension math works
The basic thing to know about the pension is a concept of relief at source. It pretty much means that government adds 20% to whatever you contributed to your pension. For example if you were able to pay in £32k today into your SIPP government will top it up with £8k. That is usually handled automatically by your SIPP provider. Your total pension contribution would be £40k.
Total contribution in a given tax year is limited according to a set of rules:
- it cannot be more than your yearly income
- maximum annual contribution is £40k
- if you earn above £150k your pension allowance gets reduced by £1 for every £2 you earn, down to £10k at the income level of £210k and above
- you could contribute more if you have unused allowances from previous years
If you are a higher taxpayer and above taxman deal can be much nicer to you. You can (or rather should) request a tax refund. Every pound from your total contribution extends your basic rate tax bracket. In the example given above, £40k total pension contribution moves higher rate threshold above default £50k to £90k. Crucially your personal allowance limit taper gets pushed from £100k to £140k. That means that if you earn £140k and contribute £32k of take home salary into your pension you can avoid an effective income tax rate of 60%.
Pension contribution example calculations
This table tries to illustrate different contribution levels and amount of tax relief you receive. For simplicity purposes I’ve skipped National Insurance values from calculations. These calculations are done for tax year 2019 / 2020:
|Salary||Base Income Tax||After Tax To Pension||Tax Relief||Relief At Source||Pension Pot||Take Home||Total||Relief|
- Base Income Tax - This is income tax that you pay on your salary before tax relief
- After Tax To Pension - Your total contribution to a pension with after tax money
- Tax Relief - Tax that you can reclaim from HMRC
- Relief At Source - Amount that is added by HMRC to your pension pot
- Pension Pot - Total amount in your pension with after tax money contribution plus Relief At Source
- Take Home - Amount that you are left after pension contribution plus reclaimed Tax Relief.
- Total - That’s total of Take Home and Pension Pot
- Relief - Effective tax relief
- If you earn above £100k it’s critical to understand how much your contributions effectively cost you. In the most extreme case if you earn £125k last £25k is taxed at 60%. If you do not contribute to a pension at all that means that you pay £42.5k of income tax that leaves you with £82.5k of take home money (again, no NI for simplicity). If you however contribute to pension £20k of after tax money your total pension pot is going to be £25k. Next you can request tax relief from HMRC of £10k. That means that your take home money is going to be £82.5k - £20k + £10k = £72.5k. Your £25k pension pot increase reduced your take home pay by only £10k that gives an effective tax relief of 60%.
- Amount you can contribute to a pension and effective tax rate are becoming progressively more unpleasant for those earning above additional tax rate of £150k. That’s a result of a combination of the decreasing pension allowance and a loss of the ability to avoid an effective tax rate of 60% that happens between £100k to £125k of income.
Some other ways to illustrate tax relief at different contribution levels
The first figure illustrates maximum contributions that can be done at a certain income level. Additionally it shows total tax relief achieved by this contribution.
Next figure illustrates total net worth (take home pay + pension pot) given two different pension strategies. In the first case no pension investment is done. The second case uses the maximum available pension contribution. Worth noting is how big potential boost is especially around £100k - £150k mark.
Some companies offer a salary exchange. In short a company will contribute directly to your pension. Their contribution would also include employer NI saving (the smaller your income is, the less NI company needs to pay). This will reduce your calculated income and National Insurance burden. In the example of somebody earning £125k your effective tax rate relief can be almost 67%.
Future of pensions and my personal approach
The trajectory of changes to pension rules is not very rosy for higher earners. Annual allowances keep getting smaller - from £255k for 2010 / 2011 to current £40k. Decreasing lifetime allowances and recently introduced annual allowance taper indicate that soon pension rules might become even more constrained.
Given that the future is unknown, but the trend is known, I personally max out my pension contributions. Opportunity to use preferential tax breaks might get even more limited in the future and should be seriously considered by anybody in a position to do so.
In the future I plan to explore implications of pension lifetime allowance and pension contributions maximisation strategy.
Please let me know what do you think and if you find this geeky approach to making sense of taxes any useful.