The average retired couple need £18,000 a year to cover the household essentials such as food, heating and housing, before any leisure activities are factored in, according to Which? The pension pot required to generate this level of income will be at least £410,000 for a male aged 60, or £320,000 for a male aged 65 – and more for women, who typically live longer.
Saving for retirement is more effective when people are young, owing to the magic of compounding over the decades. However, older people are more likely to be higher-rate taxpayers and therefore able to take full advantage of the generous tax relief on contributions to a pension plan that is available at their highest marginal rate. Older people may also be in line for bonuses or an inheritance that can be used to bump up their pension savings.
Higher-rate taxpayers might do well to try and save as much as possible in the next few years, as the government is considering limiting tax relief on pension contributions, perhaps to the basic rate of income tax. This was mooted just before the 2015 election by former chancellor George Osborne, but a revolt by backbenchers put paid to the plan. Any stable and secure future government is likely to revive this strategy, however, because it is hard to justify giving the lion’s share of tax relief to the nation’s wealthiest savers.
However, there is a limit on the overall amount you can contribute each tax year to a pension while receiving tax relief. This is £40,000 for the 2017/18 tax year, but it is tapered if your annual income is over £150,000, and slashed to £4,000 if you have already accessed your pension under the new freedoms.
Crucially, this £40,000 annual limit is the ‘gross’ pension contribution, including the top-up added by HM Revenue & Customs (so for a higher-rate taxpayer, HMRC would contribute £16,000 of the £40,000 total). If you’re in a final salary scheme, you will have to ask your pensions administrator to calculate an equivalent cash value for the benefits, called the ‘pension input amount’.
The £150,000 income threshold includes income from all sources, not just your salary but also taxable investments (i.e. not income from Isas) and buy-to-let properties, and even benefits in kind such as medical insurance premiums paid by your employer. The tapering means that for every £10,000 you earn over £150,000, your allowance is reduced by £5,000, down to an allowance of just £10,000 for those who earn over £210,000.
If you have already exceeded the limit or want to contribute more than £40,000 in a single tax year, you can use what is known as ‘carry forward’, which allows you to claw back any allowance left over from the previous three tax years. Otherwise, the only exemption from the annual allowance is if you are in ‘serious’ or ‘severe’ ill health, which HMRC defines as not being able to work to any significant extent up to the state retirement age.
Some employers offer salary sacrifice schemes and this is a good way to boost your pension contributions in the run-up to retirement, particularly if your outgoings have reduced as your family has flown the nest.
In this arrangement, you give up part of your salary, which your employer then pays into your pension. This will reduce your salary for national insurance contributions (NICs) calculations, and these savings can also be added to your pension pot. You will save 12 per cent a year on annual earnings between £8,164 and £45,000, and 2 per cent on anything above £45,000. Employers also benefit, currently saving 13.8 per cent in national insurance on the amounts sacrificed; some will add these savings to your pension as well.
The drawbacks of salary sacrifice have a greater impact on younger people. For example, the lower nominal salary can reduce the amount of life cover provided under an employer’s scheme, and it can also reduce the amount you would be able to borrow for a mortgage, or your entitlement to benefits such as statutory maternity pay.
If you run your own company, you can make employer contributions to your pension. These are not eligible for tax relief, but are an allowable expense that can be offset against your corporation tax bill. With corporate tax rates at 20 per cent, a £10,000 pension contribution will save the business £2,000. No national insurance is payable on these contributions, saving the company the 13.8 per cent, and employer contributions aren’t limited by your salary, which is helpful if you take only a small stipend from your company.
Other clever pension tactics
As you approach retirement you may also wish to consider other strategies that harness pension tax relief. For example, if you switch some Isa savings into your pension, then for a basic-rate taxpayer, £100 from an Isa will be worth £125 in a pension including tax relief; for a higher-rate taxpayer it would be worth £166 in a pension.
When you come to withdraw the pensions, 25 per cent of your fund is tax-free, and although income tax is payable on the remainder, most people pay income tax at a lower rate in their retirement. This means that from a tax perspective at least, switching Isa funds to a pension is usually advantageous. Furthermore, unlike Isas, pensions fall outside your estate for inheritance tax.
Boosting pension contributions can also be a way for high earners to reduce their income below £122,000, so that their personal allowance of £11,500 (in the 2017/18 tax year) is reinstated. The personal allowance is gradually withdrawn once a person’s income reaches £100,000, and it reduces to zero if their income exceeds £122,000.
If someone in the family is a non-earner, they too can claim basic-rate relief of 20 per cent on pension contributions of up to a total £3,600 per year. This will consist of a payment of £2,880, to which the taxman adds £720.
In addition, as you review your pensions in the run-up to retirement, it may be useful to bring together any workplace pensions set up over the years by different employers. Old forgotten pension pots tend to be left festering in expensive, underperforming funds, which makes a huge difference over the many years of a typical retirement. However, there may be exit penalties, so do examine the small print before you commit yourself.
To de-risk or not?
The traditional wisdom has been that people nearing retirement should switch their savings out of risky investments and into safer assets such as bonds and cash. However, this really depends on the size of your pot and how much longer you are likely to live.
If you are retiring quite early and are in good health, switching to low-risk assets will amount to cutting yourself off from decades of potential growth in assets such as equities, just when your fund is at its largest. Instead, you could reduce equity risk by diversifying some of the portfolio into less liquid alternatives such as commercial property, infrastructure and private equity funds, many of which have the added advantage that they produce an attractive income stream.
De-risking is a more suitable strategy for people who plan to buy an annuity when they retire. However, it is important to remain flexible, as the investment world changes – if interest rates rise, annuities might start looking attractive again.
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