More than a million pension savers will be spared from falling into a tax trap by this week’s Budget which has opened the door for retirement pots to become the ultimate financial planning tool.
The lifetime allowance limits the amount which can be saved into a pension to just over £1m, after which draconian charges kick in which see the taxman claw back the majority of savers’ money above the limit.
But in a shock move, Mr Hunt announced that the limit will be scrapped in April, giving a reprieve to tens of thousands of workers subject to the charge every year. More than a million more people had been expected to breach the old limit of £1.073m.
Critics said the move was a handout to the wealthiest people in the country, however analysis by insurer NFU Mutual for Telegraph Money shows that those earning a relatively modest £50,000 a year could easily amass a retirement pot which breached the old limit.
Pension experts also warned that measures such as the introduction of auto-enrolment in 2012 meant that this would have become a bigger problem over the next few decades.
Mr Hunt’s pensions bonanza also included a generous uplift in the annual allowance, from £40,000 to £60,000, which have also made pensions an excellent way of dodging death duties for those who plan ahead.
Separate changes to another obscure limit which saddled retirees who returned to work with unexpected tax bills, have also opened the door for over-55s to return to work without being unfairly penalised – and even “recycle” savings to take advantage of a little-known tax break.
Has the dial shifted from property to pensions?
Ever since Margaret Thatcher’s right-to-buy policy turned the UK into a country of homeowners, British people have seen their homes not just as their castle, but also their retirement nest egg.
For a long time, buy-to-let investments were treated favourably by the taxman. However, a series of reforms by former chancellor George Osborne meant that landlords could no longer deduct mortgage interest payments from profits, making this a far less attractive option.
Mr Hunt’s Budget on Wednesday has swung the pendulum further towards pensions.
Rebecca O’Connor, from retirement firm PensionBee, said it could soon be the case that pensions were seen as a better investment option than property.
“I think public perception is maybe a bit behind the reality,” she said. “While the tax incentives to invest in property have been disappearing, pensions have been going the other way.
“The tangibility of property is still attractive to people – but this could really shift the dial.”
She pointed out that the value of pensions are determined by the stock market and property by the property market and that investors would need to “take a view”.
She added: “It’s not a case of pensions for everyone and property for no-one, but if this doesn’t make pensions sexy then nothing will.”
Contributions to a pension pot are boosted via tax relief at your marginal rate, meaning that 80p saved by a basic-rate payer would be automatically topped up to £1. For higher-rate payers this is even more generous: £1 in a pension only effectively costs just 60p. Because many people pay higher-rate tax while working but basic-rate tax in retirement, pensions are highly incentivised.
There are other perks too, which have also become even more generous as a result of the Chancellor’s intervention. Money left in a pension, unlike in an Isa, is typically free of inheritance tax.
Usually an individual can pass an estate worth £325,000 to their descendents free of the duty, charged at 40pc. Additional allowances covering family homes and exemptions for married couples increased that value to £1m.
However, pensions are usually free of IHT but the value of this tax break was previously limited by the lifetime allowance. Its abolition makes this an almost unlimited option. Instead beneficiaries are taxed on the pension they inherit as they would be for other types of income. For non or low earners, this could mean a pension is passed on entirely free of tax.
Reprieve for the middle-classes
The Labour Party dismissed Mr Hunt’s pensions reforms as a “tax cut for the rich” and pledged to reverse it if it were to win the next election.
However, analysis by NFU Mutual suggests this is someway off the mark.
Assuming someone saves into a pension every year over a 40-year career and achieves returns of a not-overly-optimistic 5pc a year, they would not require a salary in the top 1pc to hit the old lifetime allowance.
For example, someone earning a salary of £53,350 – making them well-off but not breaking into the top 10pc of earners – would only need to be making contributions of 7.5pc, assuming these are matched by their employer, to hit £1m.
Someone earning £80,000 would need to save just 5pc.
Martin Ansell, a pensions expert at NFU Mutual, said: “Although a £1m pension sounds unobtainable to most, auto-enrolment and increases in wages to try and keep up with inflation will make them far more common in the future.
“Those in their 20s that start saving into a pension now wouldn’t necessarily need huge salaries to create a £1m pot by the time they retire.”
Although the number of people affected by the charges for breaching the lifetime allowance was low, it had escalated massively over the past decade. Between 2010 and 2021, the number of people who paid the charge rose eightfold, from 1,180 a year to 8,610, while the value of the charges soared from £37m to £382m.
Mr Ansell pointed out that some people would have stopped working or saving into a pension in order to avoid the charge, so the statistics do not tell the whole story. This has been pinpointed as a reason that NHS consultants have retired early.
Mr Ansell said: “Although few people breach the lifetime allowance tax charge at the moment, it was swiftly becoming a problem for a rising number of people.
“What the tax figures don’t show is how many people have stopped working or stopped saving into their pension so they don’t breach the limit.”
How to take advantage of the new tax breaks
With the abolition of the lifetime allowance, savvy savers can take advantage of a number of new tax breaks using their pension.
Under the changes, from April you will be able to save £60,000 a year into a pension, as long as you have income of at least that amount in the tax year you make the contribution. Under the “carry forward” rules, you could also use unused allowances from the previous three years – meaning after April 2023 you could squirrel away £180,000 in just one year.
There are existing rules that are designed to prevent people making huge transfers on their deathbed, or in the last two years of their life. However, regular large payments into a pension, which are then not used in retirement can usually be passed on.
Another cap on saving, the “money-purchase annual allowance”, has also increased substantially.
This places a lower annual allowance on the amount a person can save into a pension after they have already begun withdrawals from a “defined contribution” pot. It was introduced to prevent people abusing the pension freedoms and “recycling” cash through their pension in order to claim more tax relief.
However, it had been criticised as older people who had returned to work could very easily fall into the trap even via fairly modest or automatic pension contributions.
Mr Hunt has increased the limit from £4,000 a year to £10,000, meaning it is possible to return to work without being unfairly penalised.