The Tax Efficient Nature of Pension Contributions

November 27, 2020 – Written by Ruth McCamley

Having seen portfolios fluctuate throughout 2020 and reading our market updates, you will by now have a much better idea about the work and effort that we put into providing and maintaining portfolios for you and all of our clients.

If it were needed, you will also probably have more appreciation than at the start of the year that returns are certainly not guaranteed. Reaching a net real return of 2% annualised, ahead of inflation with your retirement savings would have likely been seen at the start of the year as sufficient, stable, somewhat unflashy but acceptable. Fast forward to November and it certainly seems to have become a much more sought-after quantity.

However, there are other ways in which clients could seek to make returns from their capital and, in effect, make their money work harder for them without having to worry about the fluctuations of the world’s investment markets. The most obvious of which are pension contributions. With 20% tax relief offered to basic rate taxpayers on contributions, and up to 40% and 45% for higher and additional rate taxpayers, they remain some of the most attractive tax benefits on offer by the UK government.

Comparing the various wrappers to invest in

Take the below example of one way in which pension contributions, properly invested, can produce long term, compounded returns in excess of inflation, but also in excess of those seen in ‘normal’ investment portfolios. It is important to note that the investment performance is for illustrative purposes only and is not guaranteed.

An individual earns a salary of £80,000 per year, and has £20,000 in the bank account. They are 50 and wish to retire at age 60. Their options are A) retain the funds in deposit savings accounts for the next 10 years, which will at best likely keep pace with inflation, B) invest the proceeds into a diversified investment ISA and begin to draw down after 10 years or C) invest the proceeds into their Self Invested Personal Pension (SIPP) for 10 years and then draw down.

£20,000 investment

 Deposit AccountInvestment ISASIPP
Net Cost£20,000£20,000£15,000
Tax Relief Received£0£0£10,000 (£5,000 basic rate relief goes direct to SIPP, £5,000 claimed through self-assessment)
Gross Contribution£20,000£20,000£25,000
Annualised Real Return over 10 years0%2%2%
Withdrawal after tax in todays money£20,000£24,379£28,403
Real Return on net contribution0%21.9%89.4%

Deposit accounts

  • In the example, the funds are placed in deposit accounts that keep pace with inflation, thereby equalling a 0% real return on the funds. In practice, deposit accounts may deliver lower rates of interest than this, making deflation a very real risk to savings over 10 years.
  • They will likely not attract enough interest to pay tax and therefore no tax will be due.
  • After 10 years, the funds can be released showing no gain or loss.
  • Although showing no return, this approach is suitable for those people who do not wish to take any investment risk or have short term needs for the monies.


  • The funds are instead invested in a diversified investment solution which over 10 years makes an annualised return ahead of inflation of 2%.
  • The funds are withdrawn for £24,379 in todays’ money with no tax liability, as all returns and gains in ISAs are free of tax.
  • The real return on the net contribution after 10 years will be 21.9%.


  • In the final scenario, £20,000 is invested into a SIPP. The investor receives a 20%, or £5,000 uplift in the form of basic-rate tax relief. Without needing to be invested, the value increases from £20,000 to £25,000.
  • As the individual is a higher-rate taxpayer earning £80,000, they are also able to claim an additional 20%, or £5,000, higher-rate tax relief back on this contribution through self-assessment. This means that the net contribution will only be £15,000 and the total tax relief claimed is 40%, or £10,000.
  • They then invest £25,000 and achieve a 2% real return and, after 10 years can withdraw the funds.
  • When they withdraw the funds from the SIPP there will likely be an income tax liability, the £25,000 fund having grown to £30,400. However, if we assume that this is the only income they take in the tax year, through use of the 25% tax free cash allowance, the 0% personal allowance and only drawing the residual funds within the 20% basic rate of tax they will make a net withdrawal of £28,403 in real terms, having only paid £2,000 in tax.
  • This releases a profit after tax on the net £15,000 contribution of 89.3%.

What we can conclude

The above scenarios illustrate:

  • The tax benefits of investing in pensions. The reason for the pension’s outperformance over the deposit account is simple to see, but compare it to the ISA and we can see that, even if they are both invested in the same investment solution, the SIPP is showing total outperformance of 67.5% over the 10 years.
  • The compound returns of the portfolio only accounts for just over 20% of the total returns seen. The majority of the returns come from pension contribution tax relief, which is also then compounded over the next 10 years. In the current climate, when seeking adequate returns in excess of inflation on a consistent basis has become a harder and more nuanced process, the returns available through prudent tax efficient investment in the accumulation stage of someone’s life can be a much more powerful tool.
  • Many clients will be higher rate taxpayers when they make pension contributions and will therefore attract higher rates of tax relief. However, a key objective we see in our clients is to keep under the higher rate of income tax in retirement. They will effectively receive higher rate tax relief on the contribution coming into the pension, but only pay basic rate tax relief and benefit from the personal allowance and 25% tax free cash allowance on the way out.
  • The assumed annualised rate of return in this piece is 2% above the rate of inflation, in line with the targeted returns for a Low/ Medium risk Tideway investment portfolio. It is important to note that the value of investments and the income derived from them may fall and you may get back less than you invested. Past performance is not a guide to future returns.

Of course, there are more considerations than those listed above that we will take into account before recommending a suitable action, for example the lifetime allowance, previous years unused allowances available through carry forward, the tapered annual allowance, as well as changes to tax rules. We also fully take into account your needs and objectives for those funds and the varying time horizons for accessing them.

If you would like to speak about your own unique situation and requirements, please contact your wealth manager or book in for a review of your circumstances.

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