Another Blow For Pensions

by Cliff D'Arcy on 22 March 2007  |  0 comments
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Changes made in yesterday's Budget mean that you need to increase your pension contributions by 2.6%. Here's why.

In his final Budget as Chancellor, Gordon Brown announced umpteen changes to personal tax levels and allowances on Wednesday. The headline news was a cut in the basic rate of income tax from 22% to 20%.

My colleague, Jane Mack, has shown in this article why this reduction was largely smoke and mirrors. However, I'd like to take a quick look on the impact of this cut on pensions. Reducing basic-rate tax to 20% will have one nasty knock-on effect for people who are saving for retirement using pensions.

As you may be aware, contributions to pension schemes attract tax relief at your highest rate of tax. Given that only one in nine workers (11%) pays higher-rate tax at the 40% level, for most of us, contributions to pensions presently earn 22% tax relief.

In other words, basic-rate tax relief turns a £100 pension contribution into £128.21 (because 100/78% is 128.21). However, when basic-rate tax falls to 20%, the relevant tax relief will also drop to 20%. Hence, a £100 contribution will soon be worth only £125 (because 100/80% is 125).

Therefore, in order to maintain your gross pension contributions (including tax relief) at the same level, you'll need to increase them by a few percent. To be precise, you'll have to lift them by 3.21 divided by 125, or 2.6%, which means handing over £102.60 instead of your original £100. So, although a cut in income tax may at first appear to be good news, supposedly generous government handouts are rarely what they seem!

Then again, one piece of welcome news to emerge from the Budget is the announcement of an improved safety net for workers and pensioners who lost their pensions when their employers went bust or closed under-funded pension schemes.

The enhanced Financial Assistance Scheme (FAS) will be extended to cover 125,000 people, instead of 45,000. In addition, the FAS will now guarantee four-fifths (80%) of victims' company pensions, with the maximum pension increased to £26,000. Although this is good news, where will Gordon find the extra £6 billion to pay for it? He'll either borrow it or collect it through higher taxation, of course!

More:Six Pension Setbacks and Pensioners 1, Government 0.