A tax quirk offers some savers huge returns – safely and legally.
How would you like a lifelong income of more than £5,000 a year from an
investment of just £4,750? In other words, an income equal to 105pc of your
capital.
To buy that income would normally require a retirement savings pot of nearly
£100,000.
It sounds like the marketing pitch for a too-good-to-be-true Ponzi scheme, but
it is actually available risk-free and quite legally – although only to a
relatively small group of well-off savers.
The extraordinary returns result from a quirk of the tax system that affects
people who earn between £100,000 and roughly £120,000. These people
effectively pay an income tax rate of 60pc because they progressively lose
their tax-free personal allowance.
This, of course, causes any pension
contributions they make to be even more tax-efficient than normal.
Some of the spectacular gain also results from savers' ability to recoup some
of their original outlay by withdrawing a quarter of their pension fund as
tax-free cash.
Here we provide a step-by-step guide to getting these returns, which relies on making the most of pension contributions for 10 consecutive years to get the returns suggested above. But even following the system for one year will pay dividends.
Anyone who earns between £100,000 and £118,880 pays 60pc tax on the part above £100,000 because the personal allowance – the first £9,440 of income, on which no tax is payable – is withdrawn at the rate of £1 for every £2 earned.
But someone in that earnings band can recover their personal allowance by paying enough into their pension to bring their taxable income back below £100,000.
To keep things simple we'll look at someone earning £110,000 a year, so that a £10,000 pension contribution every year will reduce taxable income to £100,000.
First of all there is the "normal" tax relief on pension contributions, which in this case is at 40pc. This brings the cost of the £10,000 contribution down to £6,000. But the saver also recovers all of his or her personal allowance, which saves a further £2,000 in tax and takes the true cost of the contribution to £4,000.
Over 10 years, the effective pension contributions total £40,000.
Now we'll look at what those contributions will produce. According to Vince Smith-Hughes of Prudential, the end result after 10 years will be a pension pot of £141,000, assuming 7pc investment growth and the charges on his company's flexible retirement plan.
Savers aged 55 or over can withdraw a quarter of their pension fund as tax-free cash, which in this case would come to £35,250. Subtracting this sum from the original contributions means that the cost of the fund is just £4,750.
The remaining pension pot is worth £105,750. Assuming an annuity rate of 5pc, this would produce an annual income for life of £5,287. In other words, you would receive more each year than the amount you originally invested – an unheard-of result from a safe, legal scheme.
Mr Smith-Hughes added: "Pensions are unbeatable investments for most people. For those caught in the personal allowance tax trap, they are outstanding investments. If you are close to or over 55, the benefits of pension investments can be achieved very quickly, and can produce some incredible rates of return."
For people who earn more than £118,880 a year, the technique still works, but the 60pc tax relief applies only to earnings in the £100,000-£118,880 band. Above the higher figure, the marginal tax rate drops back down to 40pc. If you earn more than £150,000 you won't be able to bring your taxable income down below £100,000, as the most you can pay into a pension is £50,000 a year, falling to £40,000 next April.
However, reducing your taxable income below £118,880 will allow you to claim back some of the personal allowance; remember also that you can "carry forward" unused pension contributions for up to the previous three years. Next year the personal allowance will rise to £10,000, meaning that high earners will be able to get 60pc tax relief on pension contributions of up to £20,000 a year.
A similar advantage can be gained by those who have lost some or all of their child benefit. In January it was stripped from families with an earner on more than £60,000 and gradually reduced for those earning between £50,000 and £60,000.
As a result, the Institute for Fiscal Studies has said that 320,000 people face a marginal income tax rate of more than 50pc and about 40,000 – those with three or more children – face an effective tax rate of 65pc.
Investing in a pension to reduce taxable income to below £50,000 would therefore be very cost-effective for families that can afford to do so.
Here we provide a step-by-step guide to getting these returns, which relies on making the most of pension contributions for 10 consecutive years to get the returns suggested above. But even following the system for one year will pay dividends.
Anyone who earns between £100,000 and £118,880 pays 60pc tax on the part above £100,000 because the personal allowance – the first £9,440 of income, on which no tax is payable – is withdrawn at the rate of £1 for every £2 earned.
But someone in that earnings band can recover their personal allowance by paying enough into their pension to bring their taxable income back below £100,000.
To keep things simple we'll look at someone earning £110,000 a year, so that a £10,000 pension contribution every year will reduce taxable income to £100,000.
First of all there is the "normal" tax relief on pension contributions, which in this case is at 40pc. This brings the cost of the £10,000 contribution down to £6,000. But the saver also recovers all of his or her personal allowance, which saves a further £2,000 in tax and takes the true cost of the contribution to £4,000.
Over 10 years, the effective pension contributions total £40,000.
Now we'll look at what those contributions will produce. According to Vince Smith-Hughes of Prudential, the end result after 10 years will be a pension pot of £141,000, assuming 7pc investment growth and the charges on his company's flexible retirement plan.
Savers aged 55 or over can withdraw a quarter of their pension fund as tax-free cash, which in this case would come to £35,250. Subtracting this sum from the original contributions means that the cost of the fund is just £4,750.
The remaining pension pot is worth £105,750. Assuming an annuity rate of 5pc, this would produce an annual income for life of £5,287. In other words, you would receive more each year than the amount you originally invested – an unheard-of result from a safe, legal scheme.
Mr Smith-Hughes added: "Pensions are unbeatable investments for most people. For those caught in the personal allowance tax trap, they are outstanding investments. If you are close to or over 55, the benefits of pension investments can be achieved very quickly, and can produce some incredible rates of return."
For people who earn more than £118,880 a year, the technique still works, but the 60pc tax relief applies only to earnings in the £100,000-£118,880 band. Above the higher figure, the marginal tax rate drops back down to 40pc. If you earn more than £150,000 you won't be able to bring your taxable income down below £100,000, as the most you can pay into a pension is £50,000 a year, falling to £40,000 next April.
However, reducing your taxable income below £118,880 will allow you to claim back some of the personal allowance; remember also that you can "carry forward" unused pension contributions for up to the previous three years. Next year the personal allowance will rise to £10,000, meaning that high earners will be able to get 60pc tax relief on pension contributions of up to £20,000 a year.
A similar advantage can be gained by those who have lost some or all of their child benefit. In January it was stripped from families with an earner on more than £60,000 and gradually reduced for those earning between £50,000 and £60,000.
As a result, the Institute for Fiscal Studies has said that 320,000 people face a marginal income tax rate of more than 50pc and about 40,000 – those with three or more children – face an effective tax rate of 65pc.
Investing in a pension to reduce taxable income to below £50,000 would therefore be very cost-effective for families that can afford to do so.
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