What the Budget means for pension planning
Whether you are new to investing or approaching your autumn years, pensions are likely to be an important consideration, by Rob Morgan
Almost everyone includes a comfortable retirement as one of their financial goals, and because payments into a pension receive a substantial boost from tax relief they are a highly efficient way to build provision.
In yesterday’s Budget, the Chancellor made it easier for people to enhance their pension pots with significant increases to pension allowances. The changes could help many people build up their retirement nest eggs, especially if they are playing catch up due to missed contributions in earlier years or gaps in employment. It could amount to a pension planning ‘revolution’ after successive years of cuts and freezes to allowances.
How pension tax relief works
Currently, anyone under 75 with relevant UK earnings can receive tax relief when they make a contribution within the annual allowance to a personal pension. HMRC adds 20% and any further higher or additional rate income tax relief can be reclaimed.
For example, an investor contributes £8,000 into their SIPP and £2,000 is claimed back from HMRC by the pension provider. A higher rate taxpayer could claim back up to a further 20% via their tax return, reducing the overall cost of the contribution to as little as £6,000. In the same instance, additional rate taxpayers could claim back up to a further 25% making the cost just £5,500 for a £10,000 contribution.
That’s a huge boost to your money right away, and an uplift that would otherwise only come with lots of risk or plenty of time in the market.
How much can you now contribute to pensions?
The generosity of tax relief comes with limits. Contributions that attract relief are restricted to 100% of your relevant UK earnings – essentially earned income rather than any other form of income such as dividends or interest. Contributions, including those paid by your employer, are also subject to an annual allowance of, usually, £40,000. However, in the Chancellor’s Budget, the limit was increased to £60,000 from the 2023/24 tax year. For those whose earnings vary greatly from year to year this offers significantly more scope to upsize contributions and better plan for retirement.
Higher earners get a lower annual allowance, which currently limits their maximum contribution to as little as £4,000 a year. The rules on when this ‘tapered annual allowance’ kicks in are notoriously complicated – HMRC has more information on how to calculate it at the current levels here. Following the Budget, these rules remains in place but with a higher minimum allowance of £10,000 and a tweak to the calculations involved – for the pension geeks, the ‘adjusted income threshold’ rises from £240,000 to £260,000 from 6 April 2023.
Importantly, the Chancellor also took the opportunity to reform the money purchase annual allowance (MPAA), an unwelcome complexity that stands in the way of some retirees wishing to return to the workforce. The MPAA reduces the standard annual allowance to as little as £4,000 for those who have started taking taxable income from pension pots that remain invested. It can penalise those that have been forced to draw on their pension early to cover unexpected costs or fill a gap in employment income. When they attempt to rebuild their pension pots, including through employer contributions, they face a much-reduced allowance. The increase in the MPAA to around £10,000 from next tax year (2023/24) could make a real difference to those who have dipped into their pots to combat cost-of-living challenges and could help encourage some retirees back into work.
It remains possible to carry forward pension annual allowances for up to three previous years, provided your earnings are high enough and you have been a member of a registered pension scheme in those preceding years. People earning more than £40,000 (£60,000 next tax year) who wish to maximise pension contributions may be able to take advantage this year and additional guidance and examples can be found on the government’s money helper website.
How much can you now accumulate in total in pensions?
The Lifetime Allowance (or LTA) is the limit on the amount of pension benefits you can accumulate before being hit with a tax charge – typically when you take benefits for the first time or upon reaching 75. It was as much as £1.8m up to 2012 before being cut several times to yesterday’s level of £1.073m. Having previously been frozen until 2026, it will now disappear altogether. With rumours circulating that it was to rise to £1.8m this was Mr Hunt’s ‘rabbit out of the hat’ moment, and this particular bunny should help many people build a better retirement and steer clear of complexity. It could also mean some skilled and experienced people who are close to, or over, the limit could be encouraged back into work, or to work for longer, as they could accrue further pension provision without being penalised or complicating their tax affairs.
This is especially relevant for certain NHS professionals where the limit has been cited as a frequent obstacle to a much-needed return to the workplace. Defined benefit pension schemes are usually valued at 20 times the pension income in the first year plus any lump sum, so a comfortable but not outlandish pension of around £50,000 a year has historically been caught by the LTA. Yet it has applied to anyone that has built up significant pension provision and worries about overstepping the mark.
While this is a welcome move for pension planning, there is some devil in the detail in terms of a limit on the value of any pension lump sum. For those without previous pension ‘protections’, the maximum will be retained at £268,275, 25% of the current LTA. This essentially limits the tax free cash available to retirees, as opposed to the overall value of the pensions accumulated. With the rest of any pension taken as taxable income it means a progressively higher tax rate on larger pensions, which seems a pragmatic step and a good compromise in terms of simplifying the rules.
Previous ‘protections’ to the LTA where savers kept older allowances in exchange for keeping to certain rules such as not adding further money essentially fall away with the unlimited pension size from April, though they may still be retained in respect of protected tax free cash amounts.
Rob Morgan is Chief Investment Analyst at Charles Stanley