Join our community of smart investors

Pension rules are complex but it pays to understand them

I had a good chat with someone who had just turned 40 the other week who was wondering how he could invest as tax efficiently as possible. He estimated that his earnings would be around £200,000 this year, although his job in technology sales means that this has fluctuated from year to year. 

He said that he’s hardly built up any pension and is currently paying as little as possible into his workplace scheme because he doesn’t want to be hit with the annual allowance tax charge which would be at his marginal rate of income tax. This effectively removes the tax benefit of your pension, so your money is locked up until you are age 55, or from 2028 57, without this perk. 

What he didn’t realise, though, is that the government increased the adjusted income limit by £90,000 in 2020 to £240,000 including pension contributions. For every £2 your income goes over this amount, your allowance for the current tax year reduces by £1. The minimum reduced annual allowance in the current tax year is £4,000 when your income hits £312,000 or higher. But you can carry forward three years of unused pension allowances, subject to certain criteria. 

Pensions have seen slews of major changes in recent years so it’s important to keep on top of the rules from year to year to make sure that you optimise the most generous tax break available – even if it is not as generous as it once was. In 2011, major pension changes saw the amount you could pay into a pension cut drastically from £255,000 to £50,000 per year. 

Tapering for high earners is relatively new, introduced in 2016 with an adjusted income limit of £150,000 and a minimum allowance of £10,000. While the income limit has gone up, the minimum allowance has shrunk. The problem with the tapering structure is that it disincentivises high earners from saving for retirement. As we are frequently reminded that the country is walking into a pensions crisis, surely it would be better to encourage long-term saving, including among high earners? Perhaps by reducing the tax relief for those on incomes above a certain level to the basic rate so everyone is treated equally. 

As Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown, puts it: “The tax relief system is overly complex and can make it difficult for people to put aside enough to get a decent retirement. It’s the result of constant tinkering that has led to unintended consequences.”

The government should think seriously about making the pension tax system easier to navigate and remove these kinds of disincentives. But I won’t hold my breath.