Gain without pain

The Government wants us all to save for a pension. So much so that it spends at least £14 billion a year to encourage us. That is the official cost of tax relief on pension contributions (though some commentators say the real figure is more like £20 billion a year). And once you are over fifty you can take advantage of this generosity in some cases to double your money.

Tax relief works like this. You write a cheque for £100 to your pension fund. Gordon Brown writes another for £28.20 representing the tax you have already paid. Total in your fund £128.20. So you’ve made 28% on your money at once. And if you are a higher rate taxpayer the news is even better. When you fill in your self-assessment tax return you claim back £23.08, so the £128.20 in your pension fund has cost you less than £77. In other words the amount you have put in has been boosted by nearly 67%. No wonder that more than half the money spent on pension tax relief goes to the wealthiest one in eight taxpayers who pay higher rate tax. For them putting money in a pension is a no-brainer. All of this is, of course, the repayment of tax already paid. But the people who gain the most are those on low incomes and pay no tax or only pay tax at the lower 10% rate. They still get the full basic rate tax repaid even though they have not paid it in the first place. So they put in £100 and Gordon still writes a cheque for £28.20. That is a straight gift to non-taxpayers and is about £17 more than the tax paid at the lower rate.

So paying more into your pension is usually a good idea.

Added years magic
If you are in work and already pay into a pension which is related to your salary you should ask about buying what are called ‘added years’. They are the very best way to boost your pension. In a typical salary related pension scheme you are paid a pension of 1/60^th of your pay for each year you pay into it. So if you are in the scheme for 15 years before you reach pension age you get 15/60 = ¼ of your pay when you retire. So if your salary is £24,000 you will get a pension of £6000 a year for life and that will rise with inflation up to 2.5% a year. Each added year adds 1/60^th of your pay to your pension – an extra £400 a year. To buy a pension like that would cost around £8,000. But buying an added year will cost you far less than that – maybe half as much – and you can spread the cost over two years or sometimes more. So added years are usually a bargain. But, and it is a big but, many schemes no longer let you buy added years and others are ending them soon. So act quickly.

Pay in more
The other type of company pension scheme does not promise you a pension related to your salary. It just invests all the contributions and when you reach the scheme pension age you can then convert that fund into a pension, normally by buying an annuity (see Saga Magazine February 2007). They are called Defined Contribution (DC) or Money Purchase schemes. You cannot buy added years in these but some of them do let members choose the percentage of their pay they contribute to the scheme. If the member puts in more the employer normally puts in extra as well. If your scheme gives you this choice then it is sensible to put in the amount that maximises your employer’s contribution.

Another alternative is paying into an extra pension. Until April 2006 all company pension schemes had to give you the option of paying into what were called AVCs or Additional Voluntary Contributions. Almost all schemes still offer AVCs and the employer will have negotiated good terms so if you want to put more into an extra pension then going for the company AVCs can be the cheapest way to do it.

Restrictions that used to apply to AVCs were removed in April 2006 and any employee can now put in just about as much as they can afford (see box for limits). You can take a quarter of the AVC fund as a tax-free lump-sum – though some AVC scheme have not updated their rules to allow that so check if yours has.

Instead of AVCs you can buy a personal pension. If you want the cheapest and simplest then a stakeholder pension that tracks the overall performance of the stock market can be bought with charges as low as 0.5% of the fund a year. If you want to take a gamble and pick a fund that is managed and hopes to do better than the stock market, you will pay 1% to 1.5% a year. Some funds do much better than the stock market but it is impossible to pick them in advance. A financial adviser can help.

Trick recyclist
Once you are fifty the opportunities to make use of the tax rules grows. It is called recycling. And within certain limits it is legal. Here is how it works. You start a new personal pension and write a cheque to My New Pension Fund for £780. The Chancellor, bless him, immediately gets out his cheque book and writes a cheque to Your New Pension Fund for £220. So there is £1000 in there. But as you are already fifty you can immediately declare what is poetically called a ‘benefit crystallization event’. We used to call it ‘retirement’ but nowadays it does not mean you have to stop work or stop paying into your fund. At this point you can take out a quarter of your fund in cash. So your fund writes you a cheque for £250. That leaves a pension fund of £750 which has cost you just £780 - £250 = £530. So for every £100 you have put in, there is in fact £141 in your fund. If you want you can then put that tax-free cash straight back into your pension. And yes, the Chancellor will give you a bit more. You can do this several times. It is called recycling and there are limits on it – never take out a cash lump sum for more than £15,000 is the easiest one to remember. But in fact you do not need to recycle at all. All you need to do is decide how much you can afford to put in your pension. Say that is about £1000. Add 50% and write out a cheque to your pension fund for £1500. The Chancellor adds £423 so your fund is £1923 and you claim back your 25% tax-free which is £481. That leaves your fund at £1442 and the cost to you has been £1019.

If you are a higher rate taxpayer the arithmetic is even better. You can safely write a cheque for 2¼ times the amount you really want to pay into your pension. Again, supposing you think you can afford about £1000. You write a cheque for £2250, Gordon writes one for £634, you take back tax free cash of £721 and then reclaim higher rate tax of £519. So you have spent £2250 - £721 - £519 = £1010 and in your fund is £2163. It feels like magic. But it is just benefit crystallization!

Of course once money is in a pension fund you are limited in what you can do with it. The money left in the fund can just stay there and grow – you can even pay more in if you want. If the fund grows you can take 25% of the growth as another tax-free lump sum at a later date. And you can decide when to convert it into a pension or draw an income from it right up to the age of 75.

May 2007