Why consider pensions?

Nobody likes to talk about it, but you need money to live until you die. So, why is it often this aspect of financial planning that is forgotten?

Perhaps it feels distant and isn’t important right now. There are other priorities – new house, renovations, family, new car, or just keeping up with the Joneses. Keeping up with the Joneses is a phrase that makes me laugh, but it holds value here.

People put so much into the present that they forget about the future; we know it’ll arrive quicker than we realise. I think I can speak for everybody and say nobody wants to run out of money once they reach the age at which they can’t do much about it.

Accountants aren’t regulated to give financial advice, but one thing that is obvious to all of us is that your investments compound the earlier you start.

From a tax perspective, one part of your longer-term strategy may be pension contributions, and I’m going to illustrate why. Beyond tax savings, pensions do have flaws. You can’t access the funds until you’re 55 (except in exceptional circumstances), and you’re predicting the future because you don’t know what the tax rates/allowances will be when you reach that age. These reasons deter people from pension contributions, and they opt for other options, such as ISAs, which are easier to access. You could still do pensions, but using a lower amount of funds, so you balance the funds you can/can’t access.

There are two illustrations in the email – one for those operating as a limited company and one for employees and those operating as sole traders. Feel free to drop down to the section that relates to you.

Limited Company

Your business may have £6,000 available to toy around with. You’ve got four options – leave it there, pay it to yourself, reinvest it in the business or invest it. The first two won’t reduce your Corporation Tax, and the last two will. The difference in the final two is that the first is a guaranteed cost; you’re spending money somewhere, whether that’s new tech, staff or software, etc. There’s only so much you can do, and the tax savings are only a percentage of what you spend, so you shouldn’t spend for the sake of it. This leaves investing, where you can lose money, but you’d probably not view it as you would when spending money.

You could put £6,000 into a pension, which would reduce the business’s taxable profits by this amount. The tax savings differ based on the bracket your taxable profits fall in. The savings are 19% if profits are under £50,000, 26.5% if profits are between £50,000 and £250,000, and 25% if profits are above £250,000.

For this illustration, we’ll focus on the lowest saving of 19%, which is £1,140. The pension contribution has cost £4,860 (£6,000 investment minus the reduction in Corporation Tax).

Over time, you’d hope the investment would grow. Let’s assume it doubles over the next 20 years and is worth £12,000.

Eventually, you need to access it. Currently, you receive 25% of your pension tax-free. Beyond the tax-free amount, it is subject to tax at the relevant tax bracket. If you were to spread this over your retirement years and you were a basic rate taxpayer, you’d pay 20% tax (England/Wales). On a £12,000 pension, that’d be £3,000 tax-free and you’d receive £7,200 from the remainder (£9,000 minus 20% tax). Overall, you have £10,200.

The alternative route is to invest personally, and you’d need to take a dividend to do this.

Dividends do not reduce your Corporation Tax relief, so to take a dividend, you’ll incur Corporation Tax first. The lowest rate of tax you’ll pay is 19% on the extra £6,000 of profit, totalling £1,140. This leaves £4,860 for you to take as a dividend. You’ll then incur personal taxes, which will fall at 8.75%, 33.75% or 39.35% depending on the tax bracket the dividends fall in. Assuming the best of 8.75%, that would leave you with £4,435. This illustration also excludes the additional burden you’d have if you have a student loan.

Personally, you have £4,435 to invest. The optimal option is to use a Stocks and Shares ISA, which would ensure all gains are tax-free. Assuming it doubles, you’re left with £8,870. Doubling would likely be harder as there are fewer funds to compound.

You could make it even trickier for yourself and use standard Stocks and Shares accounts. These are taxable, so they would increase your admin when you prepare tax returns, and potentially increase your tax liabilities. Dividends received would be taxable at the relevant tax rate. If you were to make gains on any investments, these are potentially taxable, too. Currently, you get a £3,000 tax-free capital gains allowance each tax year. After this, you pay tax at the rate the gain falls in, which is either 18% or 24%.

It’s pretty clear that on a year-by-year basis, pension contributions are a clear winner even when comparing their worst-case against the best-case scenario. There are limits that you must not breach in order to prevent issues, so please consult a tax professional before doing this.

Sole Trader

There’s fewer moving parts as a sole trader. Any contributions you make are treated as 80% of the overall contribution. For example, if you make contributions of £6,000, your pension will be topped up by £1,500 to £7,500. That top-up is tax from the government, meaning you’re recuperating some of the tax you’ll eventually pay.

If you’re a 40% taxpayer, your basic rate tax bracket (20% in England and Wales) increases by £7,500, meaning more of your income is taxed at 20%. As less is taxed at 40%, you save a further 20% in tax, reducing your tax liability by a further £1,500 (20% of the £7,500 pension contribution). Your contribution of £6,000 has resulted in you receiving £3,000 worth of tax across the pension pot and your tax return.

Many people aren’t aware that pension contributions increase the threshold at which you repay your student loan. Many people with student loans will notice their repayments barely make a dent in the growing interest on the account and are unlikely to ever be paid off. If this is likely to be the case, pension contributions are a great way of mitigating how much you repay.

Eventually, you need to access it. Currently, you receive 25% of your pension tax-free. Beyond the tax-free amount, it is subject to tax at the relevant tax bracket. If you were to spread this over your retirement years and you were a basic rate taxpayer, you’d pay 20% tax (England/Wales). Over time, you’d hope the investment would grow. Let’s assume the worst-case scenario and that you’re a basic rate taxpayer. If it were to double over the next 20 years, it is worth £15,000 (2 x your £6,000 investment plus the £1,500 tax top-up). On a £15,000 pension, that’d be £3,750 tax-free, and you’d receive £9,000 from the remainder (£11,250 minus 20% tax). Overall, you have £12,750.

If you were hesitant to use pensions, the optimal option is to use a Stocks and Shares ISA, which would ensure all gains are tax-free. Assuming it doubles, you’re left with £12,000. Doubling would likely be harder as there are fewer funds to compound.

You could make it even trickier for yourself and use standard Stocks and Shares accounts. These are taxable, so they would increase your admin when you prepare tax returns, and potentially increase your tax liabilities. Dividends received would be taxable at the relevant tax rate. If you were to make gains on any investments, these are potentially taxable, too. Currently, you get a £3,000 tax-free capital gains allowance each tax year. After this, you pay tax at the rate the gain falls in, which is either 18% or 24%.

It’s pretty clear that on a year-by-year basis, pension contributions are a clear winner. There are limits that you must not breach in order to prevent issues, so please consult a tax professional before doing this.