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I contribute to a company self sacrifice scheme where my contributions are matched by my employer. I am allowed to contribute only 9% of my salary.

by Clarkie 10 August 2012 |

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I recently increased my contributions over and above this amount (combined £1000 approx between myself and employer) by an extra £500 making £1500 in total. I am a higher rate tax payer and I have been told that what I am doing is not tax efficient and should stop the EXTRA contributions and invest the money elsewhere. Is this correct?

Alan

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79

Ed Bowsher posted
Hi Alan,

It's one you can argue either way. looking at your 'extra' £500 a month, the obvious alternative is an ISA. Assuming you don't already have a stocks and shares ISA, you could pay in all that money to the ISA, amounting to £6000 a year.

Although you wouldn't get any tax relief when you invest in the ISA, you'll gain when you come to withdraw money from the ISA. That's becos you can withdraw money from an ISA tax free, whereas any pension income is liable to income tax.

So basically, ISAs and pensions are equal from a tax perspective. That's unless you're a higher rate taxpayer now, as you are, and you're a basic rate taxpayer when you're a pensioner. So you'll get a higher rate tax boost on any pension contributions now, and only pay 20% income tax when you take income from a pension.

Of course, ISAs are much more flexible than pensions as you can take the money when you want.

Personally, I'd pay the 9% into my pension, make sure that I was paying my fulll annual allowance into an ISA, and then put any remainder - if there is any - into a pension.

But you could make a case for putting all the money into a pension - that's assuming you'll probably be a basic rate taxpayer when you retire.

Hope I've explained this clearly...please ask if I haven't.

Ed
Posted on 10 August 2012 | Love 0 loves Report
879

MikeGG1 posted
As Ed has indicated, an ISA is tax-free but you pay the contributions from taxed income, so the result gets one lot of higher rate tax deducted during its lifetime.

Pension contributions are paid from gross income so you don't pay tax now but you pay tax when you draw the pension. Again, there is only one lot of tax deducted during its lifetime.

So, both get tax deducted only once. Other investments get taxed twice.

However, you can take 25% of your pension pot as a Tax-Free Lump Sum, so only 75% gets that tax. That should more than make up for the higher charges levied on pension.

Pension contributions gain in 2 ways. The first is where the employer pays some contributions as a consequence of you paying contributions - this is the situation in respect of your first 9% of contributions. This is not the situation in respect of the remainder of your contributions.

The second way is where your top tax rate when paying the contributions is higher than the top rate that you would expect to pay when you retire. For example, if your annual income is currently £40,000 your tax relief would be at higher rate but if your annual income after retirement would be only £20,000 you would only be liable for basic rate.

Having said that, pensions are inflexible. You can't get anything back currently before the age of 55 and expect that to rise in line with the female State Pension Age minus 10 years. That has been forecast to rise to 68 and could reach 70, so the minimum pension age could reach 60.

ISAs are much more flexible. You can access the money if you need to if/when you have lifestyle changes, such as needing deposit money for a house or if children come along so you lose an income for a while, or just an emergency fund.

In conclusion, I would pay 9% to your pension fund, then some to an ISA and then either more to your ISA or to your pension fund depending on your expected tax rate on retirement.

But you also refer to self sacrifice. Does this mean that you do not pay national Insurance contributions on any pension contributions? If so that would increase the effect of pension contributions rather than ISA contributions. However, I would still pay some ISA contributions - just not as much!

Mike
Posted on 10 August 2012 | Love 0 loves Report
79

Ed Bowsher posted
Hi,

Reading my answer again, I can see I haven't made things very clear.

To answer your original quesiton: your strategy IS tax efficient. It's more tax efficient than any other strategy because you get the combination of tax relief when you make the contribution and you can withdraw a 25% tax-free lump sum at age 55 or later. (As MIke pointed out.)

MIke has said everything else that needs saying.

Ed

Posted on 13 August 2012 | Love 0 loves Report

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