A Free Pension?

In reality, no one is going to get a free pension, but some individuals can get very close to it.  In this article we shall take a look at how the current 2011/2012 tax regulations can be used by some taxpayers to their advantage. This of course may be apt as we approach the tax year-end on 5th April 2012.

Where an individual enjoys an annual taxable income above £100,000, they will see their personal allowance taper away at the rate of £1 for every £2 of additional income.  This means that by the time their income reaches £114,950, they will have completely lost their personal allowance.  The effective rate of tax in respect of that part of their income between £100,000 and £114,950 is 60%. So an individual with total taxable income of £114,950 will be paying tax at an effective rate of 60% on £14,950.

If that individual were to contribute personally £14,950 to a personal pension plan tax relief would amount to £8,970, leaving a net cost of £5,980.  Now supposing that individual was aged 55 or over, they would be entitled to immediately withdraw a maximum tax free lump sum of 25%, equating to £3,737, leaving £11,213 invested to provide them with a pension at some point.  The net cost of this £11,213 fund after deducting Income Tax relief and the tax-free lump sum would be just £2,243.

Pension contribution	£14,950
less 60% Income Tax relief	£8,970
less tax-free cash	£3,737
Net cost	£2,243
Remaining pension fund	£11,213

Is it possible to better this result?

Suppose for example that the individual in question is aged 50 rather than 55.  They would have to wait 5 years before drawing their lump sum. Ignoring charges, if the pension investment were to grow at 5% per annum compound, the fund would increase to £19,080 and the lump sum entitlement would increase to £4,770.  The result would be a remaining pension fund of £14,310 for a net outlay of £1,210.

Pension contribution	£14,950
less 60% Income Tax relief	£8,970
less tax-free cash	£4,770
Net cost	£1,210
Remaining pension fund	£14,310

Can this be improved yet further?

What if the contribution was instead made by the individual’s employer under a salary sacrifice arrangement?  Looking back at the first example, in this case, in addition to a 60% tax saving there would also be a 2% employee’s National Insurance saving. The net outlay to the individual would be: –

Pension contribution / salary sacrificed	£14,950
less 60% Income Tax relief	£8,970
Less 2% Employee National Insurance (NI) relief	£299
less tax-free cash	£3,737
Net cost	£1,944
Remaining pension fund	£11,213

Taking this a step further, the individual’s employer would have saved 13.8% employer’s National Insurance by the employee ‘sacrificing’ £14,950 of salary in favour of a pension contribution.  The employer could, in a salary sacrifice scenario, increase the pension contributions by 13.8% to £17,013 and be in a no worse position.  So the net cost to the employee would be: –

Pension contribution / salary sacrificed	£14,950
less 60% Income Tax relief	£8,970
Less 2% Employee National Insurance (NI) relief	£299
less tax-free cash	£4,253
Net cost	£1,428
Remaining pension fund	£13,008

Furthermore, an even higher fund value of £13,008 would remain for purpose of providing pension.

If the individual in question were again aged 50, they would have to wait 5 years before drawing pension benefits.  Once more if we ignore pension fund charges and again assume 5% compound growth, this fund would increase to £21,713.  The tax-free lump sum would then be £5,428 and the individual would be left with a pension fund of £16,285 for a cost of £253, i.e.

Pension contribution / salary sacrificed	£14,950
less 60% Income Tax relief	£8,970
Less 2% Employee National Insurance (NI) relief	£299
less tax-free cash	£5,428
Net cost	£253
Remaining pension fund	£16,285

Not quite a free pension, but not far off.

A person in their late 40’s or early 50’s might repeat this planning over many years to build up a more meaningful pension fund at a very low cost to enhance whatever other plans they might have made for their retirement.

It is worth noting that individuals aged 55 or over that can benefit from the immediate withdrawal of benefits, including the tax-free cash lump sum may not reinvest or recycle this to gain further pension and tax benefits. However, recycling of excess or surplus income is permissible and we intend to cover this particular opportunity in further detail in a future article.

Planning such as this is likely to prove to be particularly useful to key individuals within a company that can influence or negotiate the structure of their remunerative package. Alternatively, perhaps individuals such as Computer Consultants, IT Contractors and Management Consultants affected by Part 8 of the Income Tax (Employment and Pensions) Act 2003, better know as IR35 could benefit.

Of course, this type of planning may also appeal to earners caught by the 50% tax band, although with less financial benefit due to the relevant tax rate.

If you would like to discuss any aspect of this planning, feel free to contact us for an informal discussion.