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Pension freedoms – an opportunity for lower paid individuals

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10 June 2015

It is widely appreciated that higher rate taxpayers can benefit from significant tax relief by contributing to a pension. Relief is currently given at 40% for pension contributions by higher rate taxpayers which on retirement can be extracted with the first 25% as a tax free lump sum and the remainder at the basic rate of tax (i.e. 20%) providing the individual’s total income for that given tax year does not exceed the relevant threshold (currently £42,385). 

For basic rate taxpayers, tax relief at 20% will be given on the way in but will then be subject to 20% tax on the way out, albeit again 25% would be received as a tax free lump sum. The previous inflexibilities on withdrawing a pension by way of an annuity, however, may have outweighed the small tax saving to be had.

With the changes to the pension rules from April 2015 it is worth considering whether the new so called ‘pension freedoms’ offer any further advantages to lower paid individuals, or indeed, those with no income at all.

With the ability now to fully draw down a pension pot from the age of 55, and without having to buy an annuity, up to a 25% return could almost immediately be achieved on a pension contribution by an individual over 55 with little or no income.

Anyone under the age of 75 is entitled to make a gross pension contribution of up to £3,600 per year. This would equate to a net contribution of £2,880 as tax relief at 20% is given even if the individual does not pay tax. In theory, therefore, a 55 year old would be able to make a net pension contribution of £2,880 in one year and withdraw the full pension of £3,600 just a year later making a return of £720 (25%). No tax would be due providing the individual’s total other annual income was less than £7,900 (based on current rates) as it would be covered by the personal tax allowance. There may be a small charge by the pension company for withdrawing the full amount which should be checked upfront. 

The following year the individual could again make a pension contribution of £2,880 and then withdraw £3,600 a year later. To the extent that the individual’s earnings are above £3,600 they can make higher contributions to a personal pension plan (i.e. up to the level of their earnings). It may not be possible to withdraw the full amount the following year free of tax though as they could be tipped into the basic tax bracket. It still may, however, prove to be more beneficial to make a higher contribution and leave any excess in the pension pot until retirement rather than leaving in a savings account. 

Given the current low interest rates a short term pension contribution would appear to be a significantly better investment than leaving savings in the bank. However, the rules are new and as yet untested and there are certain pitfalls and traps to be aware of. For example, there is an anti avoidance rule for the recycling of pension contributions which would need to be considered depending on the amount of lump sums taken in the prior 12 months.

If you have any questions, please speak to your usual Hazlewoods contact or Gary Cook on 01242 680000 or gary.cook@hazlewoods.co.uk