Pension Tax Relief - Don't Look a Gift Horse in the Mouth

This blog was written by our sister firm Aquila Financial Services, a leading provider of financial planning and wealth management solutions. Aquila helps clients achieve their financial goals and secure their future with personalised advice and tailored strategies. Whether you're seeking advice on investments, pension planning, or wealth management, Aquila has the expertise and experience to guide you.

The October 2024 Budget makes the value of pension funds potentially subject to tax on death from April 2027 by bringing them into the scope of Inheritance Tax. This means that pensions will lose their effectiveness as a means of passing wealth to family members outside of the Inheritance Tax Regime. However, they retain other advantages from the 2016 reforms and they remain highly income tax efficient for retirement planning.

Despite the loss of the Inheritance Tax advantage, contributing to a pension should still be a priority for most individuals.

Let’s look at the basics

• Contributions from an individual attract Income Tax relief at your highest marginal rate.

• Contributions from your company receive Corporation Tax relief and can be a tax efficient and legitimate way of extracting value.

• Most people are basic rate taxpayers (or non-taxpayers) in retirement, even where they have paid tax at higher rates previously

Working taxpayers may be liable to income tax at a variety of rates, for example:

• The basic rate is 20%

• A basic rate taxpayer may have an effective marginal rate of 26% in a year when a large capital gain is realised. This is because an extra 6% Capital Gains Tax is charged on gains that fall outside the (otherwise) unused part of the income tax basic rate band.

• The headline rates for higher income individuals are 40% and 45%.

• Marginal income tax rates are often higher where income is between £60,000 and £80,000, or between £100,000 and £125,140. This is because extra tax may be charged in those bands to claw back child benefit or personal allowance making an effective rate of Income Tax of up to 60%.

The following table shows the effective return available from a private pension investment by an individual who will be a basic rate taxpayer in retirement. These figures do not take into account costs or potential investment returns.

Even if the investor’s tax rate is 20% at both investment and retirement, there is a 6.25% return because the whole of the investment achieves tax relief when made, but one-quarter of the pension pot is available as a tax-free lump sum on encashment.

Where the investor’s tax rate is higher than 20%, the financial return is much higher. The financial return is 41.67% for an individual who is a higher rate taxpayer at the time of investment and a basic rate taxpayer in retirement.

Farmers have traditionally been reluctant to invest money into pensions; preferring instead to preserve cash for potential future land purchases. However, the 2016 reforms made pensions a much more flexible investment, with funds able to be drawn down from age 55 and no longer locked into a future annuity purchase

If you have funds available for pension investment, and especially if you are a higher rate taxpayer or are likely to have a raised effective tax rate in 2025/2026 due to a land sale (without business asset disposal or rollover relief) or for some other reason, please speak in good time to your independent financial adviser.