40% tax on Pension
Discussion
Hypothetically if a DB pension is going to put somebody into the higher rate tax band then is it still worth putting money into a SIPP rather than a GIA?
Advantages
You get your marginal rate tax refunded
You can still get part of it tax free (TFLS)
It transfers to your spouse free of IHT
Growth inside the pension will be tax free
Disadvantages
If your spouse dies before you it forms part of your IHT band
Your dependants also have to pay income tax at their marginal rate
Investments in a GIA give you far more flexibility to give it away before dying
Growth in a GIA is subject to tax
is there anything I'm missing?
Advantages
You get your marginal rate tax refunded
You can still get part of it tax free (TFLS)
It transfers to your spouse free of IHT
Growth inside the pension will be tax free
Disadvantages
If your spouse dies before you it forms part of your IHT band
Your dependants also have to pay income tax at their marginal rate
Investments in a GIA give you far more flexibility to give it away before dying
Growth in a GIA is subject to tax
is there anything I'm missing?
Transferring free from IHT is not specific to pension. It would be the same with GIA. Also for GIA, this would transfer at market value on death so spouse would not have CGT to pay on the gains made to date.
But as you mentioned, the biggest gain on pension is no tax while the invested fund is growing.
But as you mentioned, the biggest gain on pension is no tax while the invested fund is growing.
Yes, the main difference is "cumulation" on money that would otherwise have gone in tax.
However, the opening question is a good one. Pension will always make sense if you can get tax relief at, say, 40% on the way in and only pay tax at 20% on the way out. Obviously the same applies at 60% relief on the way in and 40% tax on the way out, and so forth. However, when the tax relief and tax payable are in alignment it's far less clear cut.
Questions arise when a well-heeled pensioner is staring down the barrel of the dreaded 60% effective tax rate. If you're going to be hit by 60% every year the case can be made for just pulling out everything in one hit at 45% so HMRC only ever get one bite at that 60% band. But it's all quite finely balanced and involves modelling income and investment returns forwards several years to make any real sense of it.
The annual cost of the 60% band is £3,750 in additional tax (15% of £25k). Not a great deal of money in itself but if you can save it 10 years in a row things start to look worth pursuing. And now Rachel Reeves has removed the ability to inherit pension tax free a lot of the magic has gone.
However, the opening question is a good one. Pension will always make sense if you can get tax relief at, say, 40% on the way in and only pay tax at 20% on the way out. Obviously the same applies at 60% relief on the way in and 40% tax on the way out, and so forth. However, when the tax relief and tax payable are in alignment it's far less clear cut.
Questions arise when a well-heeled pensioner is staring down the barrel of the dreaded 60% effective tax rate. If you're going to be hit by 60% every year the case can be made for just pulling out everything in one hit at 45% so HMRC only ever get one bite at that 60% band. But it's all quite finely balanced and involves modelling income and investment returns forwards several years to make any real sense of it.
The annual cost of the 60% band is £3,750 in additional tax (15% of £25k). Not a great deal of money in itself but if you can save it 10 years in a row things start to look worth pursuing. And now Rachel Reeves has removed the ability to inherit pension tax free a lot of the magic has gone.
Panamax said:
Yes, the main difference is "cumulation" on money that would otherwise have gone in tax.
The annual cost of the 60% band is £3,750 in additional tax (15% of £25k). Not a great deal of money in itself but if you can save it 10 years in a row things start to look worth pursuing. And now Rachel Reeves has removed the ability to inherit pension tax free a lot of the magic has gone.
You’ve said that £3750 isn’t a lot a few times. But I suspect most people would happily take free car insurance, free VED, free broadband, free water, free house insurance and a few other things free each year for life or a decent amount of time. I certainly would.The annual cost of the 60% band is £3,750 in additional tax (15% of £25k). Not a great deal of money in itself but if you can save it 10 years in a row things start to look worth pursuing. And now Rachel Reeves has removed the ability to inherit pension tax free a lot of the magic has gone.
If you’re still accumulating and can avoid the whole 45% and 60% bracket altogether then it’s more than £3750. But it starts to feel a bit like a trap where everything above that gets dumped into a pension.
It would appear that many people think that growth of untaxed money within a pension that needs tax paying on it to spend is better than the growth of taxed money outside a pension that doesn't need tax paying on it.
It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
omniflow said:
It would appear that many people think that growth of untaxed money within a pension that needs tax paying on it to spend is better than the growth of taxed money outside a pension that doesn't need tax paying on it.
It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
Why do you assume 40% income tax on the pension option, for some it can be drawn free of tax, or gradually to minimise tax.It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
Where pensions are concerned, there is sometimes the possibility of directing pension death benefits into a spousal bypass trust, rather than paying them to the spouse outright. This can help keep the pension assets outside of an individual’s estate for Inheritance Tax (IHT) purposes.
omniflow said:
It would appear that many people think that growth of untaxed money within a pension that needs tax paying on it to spend is better than the growth of taxed money outside a pension that doesn't need tax paying on it.
The total tax position has to take into account tax relief on money invested. It makes a significant difference if the tax rate on money withdrawn is lower than the rate of tax relief on money that was invested.ISA. Earn £100. Pay income tax of £40. You have £60k to cumulate in your ISA and all withdrawals are tax free.
SIPP. Earn £100. Invest £100, saving £40 of income tax. The full £100 then cumulates tax free. 25% tax free cash withdrawal - remainder taxed at 20%. You should come out ahead of the ISA.
As previously mentioned, it all depends on modelling of personal income, tax and investment returns. My broad brush suggestion is there's not a lot wrong with splitting resources 50/50 between ISA and pension.
supersport said:
If you’re still accumulating and can avoid the whole 45% and 60% bracket altogether then it’s more than £3750. But it starts to feel a bit like a trap where everything above that gets dumped into a pension.
I don't understand your first point but you're right about the trap. Really high earners can't pension their way out of it, although that remains very attractive for anyone caught in the 60% who doesn't then revert to 45% on excess income."Average" UK tax rates across different levels of income.
£50,000 p.a. = 15% tax
£75,000 p.a. = 23% tax
£100,000 p.a. = 27.5% tax
it then jumps up quickly and broadly stays there
£125,000 p.a. = 34% tax
£150,000 p.a. = 36% tax
£200,000 p.a. = 38% tax
Separately, indirect taxes including 20% VAT hit everyone but in the world of income tax higher earners are hit hard compared with Mr & Mrs Average, each earning £37,500 and paying very little income tax (just 13%) on a £75,000 combined household income. (Yes, they will be paying NI where applicable as well.)
With the government's ongoing freeze of allowances and bands, combined with wage inflation, quite a few people are going to find themselves paying a lot more tax by the end of this decade without being in any way "better off".
Panamax said:
SIPP. Earn £100. Invest £100, saving £40 of income tax. The full £100 then cumulates tax free. 25% tax free cash withdrawal - remainder taxed at 20%.
Depends on your circumstances. If you retire before state pension age, and have no other income, you can draw £12570/year tax free over and above your 25% tax free portion. Countdown said:
Hypothetically if a DB pension is going to put somebody into the higher rate tax band then is it still worth putting money into a SIPP rather than a GIA?
Advantages
You get your marginal rate tax refunded
You can still get part of it tax free (TFLS)
It transfers to your spouse free of IHT
Growth inside the pension will be tax free
Disadvantages
If your spouse dies before you it forms part of your IHT band
Your dependants also have to pay income tax at their marginal rate
Investments in a GIA give you far more flexibility to give it away before dying
Growth in a GIA is subject to tax
is there anything I'm missing?
It seems like you are missing using an ISA instead of a GIA.Advantages
You get your marginal rate tax refunded
You can still get part of it tax free (TFLS)
It transfers to your spouse free of IHT
Growth inside the pension will be tax free
Disadvantages
If your spouse dies before you it forms part of your IHT band
Your dependants also have to pay income tax at their marginal rate
Investments in a GIA give you far more flexibility to give it away before dying
Growth in a GIA is subject to tax
is there anything I'm missing?
To answer your main SIPP v GIA points, you are still better off with the SIPP contribution as you have saved 40% in tax relief and still get tax free growth and 25% tax free withdrawal. With a GIA you get none of these, for example (using simple numbers);
SIPP
- £100 earned income into SIPP = £100
- Money in SIPP grows by 100% (round number) = £200
- Tax on the 100% growth = £0
- SIPP balance = £200
- 25% tax free = £50
- 40% Income tax on the £150 balance = £60
- Total SIPP return = £140
- £100 earned income into GIA = £60
- GIA grows by 100% (same round number) = £120
- CGT on the 100% growth (24%) = £14.40
- Total GIA return = £105.60
Another SIPP over GIA advantage is that you get the higher rate tax relief back now rather than later (as only the 20% basic element goes into your pension at source) as included in the figures above. You can have this paid as either;
1) A reduction in your tax bill for the current year
2) A change to your tax code reducing the following year's tax by the same amount
3) A tax rebate
As has been said, all spouse transfers are free of IHT.
Edited to rectify an error I made.
Edited by JulianPH on Sunday 22 December 22:17
Edited by JulianPH on Thursday 26th December 21:01
omniflow said:
It would appear that many people think that growth of untaxed money within a pension that needs tax paying on it to spend is better than the growth of taxed money outside a pension that doesn't need tax paying on it.
It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
It would appear that you think GIA returns are not subject to tax, which of course they are. You would be closer if the OP was talking about ISAs, but he isn't (for some reason).It isn't. It's identical. If you strip out all of the other variables then you have sums similar to the following:
£6,000 / year for 10 years with 10% growth = £95,625, all of which is yours to spend as and when you like with no more tax to pay
£10,000 / year for 10 years with 10% growth = £159,374, but then to spend this you've got to obey all the pension rules and lose 40% in income tax which means you have a net sum of £95,625, which is identical to the sum above. Apart from the fact that you can't spend it until you reach a specific age.
Obviously, other variables come into play - employer matching and TFLS being the two main ones, but the fundamental point remains - the additional compounded growth on a taxed investment is swallowed up by the additional tax.
I'm also not quite sure how you arrived at your after tax pension figure either, other than applying 40% to the whole amount. £39,843 of that (25%) would be tax free.
Panamax said:
SIPP. Earn £100. Invest £100, saving £40 of income tax. The full £100 then cumulates tax free. 25% tax free cash withdrawal - remainder taxed at 20%. You should come out ahead of the ISA.
20%? If only. In the People's Republic of Scotland higher rate tax is paid from £43k. I anticipate by the time I reach old age pension age (in 3 years) my occupational pension will be around £30k. Old age pension around £12k. Second small occupational pension around £1500
Thereafter anything I take from my (relatively small) DC pot is taxed at SCottish higher rate 42%.
Obviously I am luckier than many to be in this position but any other cash I pay into my DC pot I would be paying 42% on the way out.
I may reduce hours enough to avoid higher rate tax for the next three years in my part time job.
My current plan (unless tax thresholds change) being to leave it there so Mrs IRC can get it if I pop my clogs first. Inheritance tax is not an issue.
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