We can all agree - one of the key roles advisers play is to make the complex seem simple. But by over-simplifying the UK tax system for your pensions clients, could you be selling yourself and the service you provide short? David Downie, Technical Consultancy Manager, Standard Life, takes a closer look at why headline rates can be misleading.
We can all agree - one of the key roles advisers play is to make the complex seem simple. But by over-simplifying the UK tax system for your pensions clients, could you be selling yourself and the service you provide short? David Downie, Technical Consultancy Manager, Standard Life, takes a closer look at why headline rates can be misleading.
Advisers often categorise clients as higher or basic rate taxpayers, and use the basic assumption that it will be either 40% or 20% on the income they receive or any tax relief given.
But just how accurate is this? I’d argue that the headlines can be misleading.
Headline - Higher rate taxpayers will get 40% relief on their pension contributions.
Essentially, pensions tax relief is given from the ‘top down’. If an individual makes a pension contribution that's matched with income in the higher rate band, they will get 40% relief on the full amount.
But if the contribution is greater than income in the higher rate band, then the ‘effective’ rate of relief is diluted – some of the payment getting relief at 40% and some at 20%.
Headline - Pension income will always be taxable at either 40% or 20%.
It should come as a pleasant surprise to some of your clients that future taxable income is actually likely to be lower than they may imagine, because the income tax system operates in tax bands. Once you factor in the personal allowance and the income tax bands, the effective rate of tax paid is much lower than the headline rates of 40% or 20%.
For example, we might think of someone with income in retirement of £50,000 as a 40% taxpayer. But they will only pay 40% tax on the top £5,000* of their income. After deducting their personal allowance and accounting for tax at 20%, the effective rate of income tax on their income is 17.4% - less than half the 40% headline rate.
And all this ignores the fact that when taking money from a pension, 25% of the payment could be tax free. Bearing this in mind, the tax on a £50,000 pension withdrawal could be as low as just 10.4%.
Headline - Once a higher rate taxpayer, always a higher rate taxpayer.
Just because a client pays higher rate tax now, it doesn’t mean this will always be the case. Most savers who pay higher rate tax during their working life don't continue to do so in retirement. There are many factors behind this, such as reduced income needs in retirement to having insufficient savings to maintain that level of income. Even taking drawdown of 5% a year from a £1M pension pot will give £50,000, which after tax free cash would be £37,500 – well below the higher rate threshold of £45,000.
It all goes to show how it’s easy to underestimate just how valuable a benefit the current tax relief system is by trying to simplify it using headline tax rates.
You can read a longer version of this article, with helpful examples, at Standard Life TechZone
*Figures are not appropriate for the Scottish tax system
Tax rules may change in the future.
Established in Edinburgh in 1825, the Standard Life group is a financial services group whose principal activities consist of the provision of life assurance and pensions, investment management, banking and healthcare insurance products with approximately 10,000 employees spread across the UK, Canada, Ireland, Germany, Austria, India, Hong Kong and mainland China
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