19th August 2015
Government suggestions that pensions could be ‘taxed like Isas’ could leave retirees much worse off because they would pay tax on their income before making pension contributions and so would miss out on the effect of compound interest on these payments.
Currently people saving into a pension can make contributions directly from their gross income so it is not taxed until they come to draw upon their funds in retirement. However, in the recent Budget the Chancellor mooted another radical shake-up of the pensions system, suggesting that your taxed income can be put into retirement savings and never be taxed again.
This move from ‘exempt-exempt-taxed’ (with pension money currently not taxed until the point of withdrawal) to ‘taxed-exempt-exempt’ may well succeed in encouraging people to save, but will ultimately lead to much smaller retirement funds, Towry, the financial adviser has warned.
Take the example of a 40 year old who earns £50,000 a year, and is putting 5% net of their wage (£2,500) into a pension fund. Currently, as a higher rate tax payer, they are benefitting from 40% pensions tax relief and so their contribution is in fact worth £4,167. Assuming the investments themselves grow at a rate of 5% each year, by the time they reach their intended retirement age of 65 they would have a pension fund of £208,822.
If Steve Webb’s suggestion of a flat rate of 33% on pension tax relief bore fruition under the current system, it would mean that the employee was making contributions of £3,731 a year, and their pension fund at 65 would total £186,973 – a loss of over £20,000.
Moreover, if the Government is to carry out this suggested new policy and only income which has already been taxed can be added into retirement funds, and the employee maintains a £2,500 contribution into their pension fund, at 65 this would total just £125,284 – a fall of over £80,000.
Even if, at age 65, the Chancellor’s promised ‘top-up from the Government’ is then delivered (at the suggested 33% rate), the fund would only total £166,627.72 – still leaving the worker with a £40,000 shortfall in their retirement funding.
Andy James, head of retirement planning, Towry, says: “Unless the Government chooses to help fund pension pots from an early stage, workers are going to miss out on vast amounts of money they would have otherwise gained through the impact of compound interest, and this is something that the consultation period will seriously need to consider. It is vital that savers receive every encouragement to put something into their retirement funds as early as possible.”