Little Contributions, Big Impact
In previous articles I have written about the tax efficient nature of pension contributions, initially as a comparison against ISAs or deposit accounts, and then later in regards to how tax relief can be used to claim back the higher rates of tax for those earning over £100,000. For this article I thought I would complete ‘the trilogy’ and write more practically about the effect those contributions can have on the type of retirement you wish to have.
Just as a brief reminder, if contributing to a pension individually, we are contributing to that pension ‘net’ of tax. The government will then ‘gross’ these contributions up by applying basic rate tax relief. So, for every £8 you pay into a pension, the government will top it up by £2 to £10, potentially all the way up to £40,000 a year. For higher and additional rate taxpayers, further tax relief can be claimed back at self-assessment and this can be used to also provide a separate stream of income and capital in retirement.
To set the scene, we will be looking at a new client of Tideway, age 50 and looking to retire age 60. They earn £80,000 a year and already have a workplace pension that, over their lifetime has amassed a fund value of £250,000. Their employer contributes 8%, or £6,400 a year, and we are going to assume that rate of contributions remains the same and the workplace pension grows at a fairly conservative 2% each year, after fees and inflation. They are also able to make regular savings from salary of just over £650 a month, or £8,000 a year, into a deposit account paying 0.01% interest annually.
After 10 years, the value of the pension would have grown to a fairly healthy level, £376,228, certainly above the average UK pot size at retirement, and they could expect to draw a 4% income yield of just over £15,000 gross a year. Total tax-free cash is £94,000 and, provided they have no other capital needs such as paying off a mortgage, this can be used annually alongside utilising their personal allowance to ensure they are drawing a tax efficient income in retirement. The money amassed in their deposit account is now value at c. £80,000 and can be used for ad hoc income needs. All in, they have around £456,228 to provide them with their retirement needs.
However, let’s go back in time and ask what if they had made their own, further contributions to pensions over the past 10 years? Instead of putting £8,000 a year into cash, what if they had used those funds to make additional pension contributions to a personal pension?
By investing £8,000 into a Personal Pension each year instead of depositing cash, the following initially takes place:
Straight away, the funds will grow in value by £2,000. 10 years of £8,000 annual contributions will equal £20,000 in basic-rate tax relief earned in that period, boosting the overall value of their investments above £456,228 without considering investment returns.
Following that, and now including 2% investment returns, we can see:
The funds grow to £111,687 over 10 years, a simple return of 39.6% or £31,687 on the £80,000 invested over that period, which is a combination of tax relief and compound growth in excess of the return on deposits.
The total combined value of the personal pension and workplace pension has now grown over the 10-year period from £456,228 to £487,915.
But wait, there’s more!
We are forgetting one important element, which will further amplify the returns already seen in our second scenario. As mentioned, our client earns £80,000 and is a higher rate taxpayer, which means not only can they claim 20% basic rate tax relief, but also a further 20% higher rate tax relief, which is claimed after the tax year via self-assessment.
Each year, the annual contribution and tax relief now look like this:
The extra £2,000 tax relief, once claimed, is now immediately available to the client and could then be used each year from age 51 to 60 to fund additional non-pension investments, for example in a Stocks & Shares ISA. Over 10 years, this will equal a further £20,000 invested:
The investment growth over this period may be fairly negligible in £ terms, but it’s important to remember that none of these funds have come from capital, rather from tax relief paid by the government on the pension contributions.
After 10 years the combined Personal Pension and ISA value would be £134,025, a return on the original £80,000 invested into the Personal Pension of 67.5%.
The total value of all retirement savings will also increase from £456,228 to £510,253:
As all funds are now invested and have earned tax relief and investment growth over the past 10 years, a 4% return from the income yield would now support a £20,410 gross annual income yield, which is a 35.6% increase from our first scenario. Further tax-free cash is available from the Personal Pension and the ISAs are tax-free on withdrawal.
The aim of this article is to illustrate the power of pension tax relief which, over a number of years’ incremental contributions and gains, can achieve dramatic changes to someone’s retirement plans and future standards of living, no matter their starting level or how much they are able to save.
I have purposefully tried to use fairly conservative numbers for a client of Tideway building their retirement savings, utilising just over £650 p.m. unused income to fund the contributions. You can scale the example up or down to suit your own situation, risk appetite and retirement income goals.
We have several drawdown calculators suitable for those considering their retirement on our website, which can help give you an idea of how much you may need to enjoy your desired level of income and capital in retirement.
If you would like to further discuss what additional contributions you could make to your pension, and what changes these could bring to your future income over time, please get in touch with your wealth manager or make an enquiry on our website.
Checking Fundamentals, 23/07/2021
Half Time 2021, 09/07/2021