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Pensions are still top dog (for basic rate tax payers)
Tax relief may be under threat for higher rate tax payers but pensions are still the best way to save for anybody on basic rate tax.
by Michelle McGagh on Feb 16, 2016 at 14:47
The government may be planning to cut tax relief on pension savings but they still remain the most tax-efficient way to save, trumping property and ISAs (individual savings accounts).
While everyone is told to save more the government is making the decision about where to save harder by chopping and changing the tax incentives and increasing the risk of saving in the wrong ‘wrapper’.
The Institute of Fiscal Studies (IFS) has examined the main savings options on offer, including pensions, ISAs, shares portfolios and buy-to-let investments to work out where you should put your cash.
There are arguments for all forms of saving; ISA limits have increased to £15,240 for 2016/17 and from April savers will be able to take money out of their ISA without losing any of their annual allowance – this means you can save £15,240 into your ISA, take out £1,000 and then put that £1,000 back in later on, which you couldn’t do before.
Those saving outside an ISA will be able to benefit from the new dividend allowance which means no tax on the first £5,000 of dividend income earned.
A personal savings allowance of £1,000 means even the money you save in the bank can be saved tax-free. This means 16 million people will stop paying any interest on their savings income.
It’s not good news for all savings and investments though: buy-to-let landlords are being deterred by new taxes, which the government hopes will stem the flow of second property owners.
From April, second property buyers will have to pay an extra 3% stamp duty and the government will phase in a cut to the tax relief available for landlord’s mortgage interest.
The IFS figures show that the new tax rates will ‘significantly reduce the attractiveness of buy-to-let housing as an investment a mong higher rate taxpayers’.
It calculated that a 10 year buy-to-let property, financed 50% by a mortgage would see ‘the effective tax rate’ increase from 47% to 76% for a higher-rate taxpayer.
This is where pensions step in.
The IFS said ‘pensions remain the most tax-efficient major form of saving’ and it’s all to do with your employer contribution.
If you save into a pension it is likely that you contribute to one set up by your workplace and there’s also a chance that you were auto-enrolled into it. Under the auto-enrolment rules your employer has to contribute too.
On top of that you receive tax relief from the government.
At the moment, the minimum amount that must be saved into an auto-enrolment pension is around 2% of salary, made up of 1% employee contribution, 1% employer contribution and 0.2% from the government.
By 2017, this will increase to 8%: made up of 4% employee contribution, 3% employer contribution and 1% tax relief.
However, the government is consulting on tax relief changes and the IFS said it was likely one of two major reforms would happen. Either, tax relief will be reduced to a flat rate for everyone (you currently receive relief based on the highest rate of income tax you pay) or upfront tax relief will be scrapped and pensions savings will be untaxed when they are received (you currently pay income tax on pension income in retirement).
But even this major shake-up of pensions isn’t enough to make pensions unattractive, at least not for basic-rate taxpayers paying 20% income tax who receive 20% tax relief compared to 40% relief received by higher rate taxpayers.
‘Moving to flat-rate relief would make incentives to save in a pension stronger for basic-rate taxpayers and weaker for higher-rate taxpayers,’ said Stuart Adam, author of the IFS report into the effects of savings incentives.
‘Indeed if the rate of relief were less than 30%, higher rate taxpayers who expect to pay the higher rate in retirement as well would be actively discouraged by the tax system from making employee pension contributions.’
Adam added that if income tax relief on pension contributions and tax on pension income were abolished, the incentive to save in a pension would no longer depend on individual tax positions but on the generosity of the contribution the government would give.
Whatever way the government decides to slice pension tax relief, Adam said the important boost provided by pensions is via the employer contribution.
‘Employer contributions to pensions are especially strongly favoured because of generous treatment in the national insurance system,’ he said. ‘For a basic-rate taxpayer a contribution to a pension by their employer with a net cost of £70 is worth the same as a £100 contribution to an ISA.’
Under the auto-enrolment system Adam said employees would get a pension ‘60% bigger than without the [employer] match’.
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