From April next year, you will be able to invest up to £50,000 a year into a pension and receive tax relief on that money. This is known as the annual allowance.
However, while this may sound generous it is actually quite a sizeable reduction as the current rules allow people to invest up to £255,000 a year.
The other main change is that the maximum lifetime allowance is being cut from £1.8million to £1.5million. In other words, tax relief is only available on pension pots up to the value of £1.5million.
Why have these changes been announced?
It’s another initiative aimed at reducing the size of the budget deficit. By reducing the tax relief on pensions it will boost the revenue the government generates from the tax we pay on savings.
The government says the changes to pension legislation will net it around £4billion a year in extra revenue.
Although the new rules lessen the tax advantage of investing in a pension, they have been generally welcomed by the industry. The reason is that the majority of people won’t be hit by these changes and also, the proposals are far simpler than pension reforms that had been proposed by the former Labour government. It announced plans to gradually reduce the tax relief available to those earning £150,000 or more to 20%.
Under the coalition government’s plans, it appears as though savers will continue to receive tax relief based on their income tax band as nothing regarding a reduction has been mentioned. Therefore, higher-rate taxpayers will get 40% tax relief on pension contributions, while those in the top tax band receive 50% tax relief.
Who will this affect?
Most people won’t be adversely affected by the new rules as the amount they contribute to their pension each year is well below the lower £50,000 limit. However, some high earners do pay more than this into their pensions and it is thought that around 100,000 people will be hit by the reduction in the annual allowance.
What happens if I exceed the annual pension allowance?
You can pay more than £50,000 into your pension, but tax will be payable on any contributions that take you over that limit. Similarly, you won’t receive tax relief if the total amount you pay into your pension pot exceeds £1.5million.
Is it worth having a pension?
Despite a dilution in the tax advantages, a pension is still worth investing in. For every £1 you pay into your pension, a basic-rate taxpayer receives £1.20 in his or her pension pot, while a 40% taxpayer receives £1.40 and someone in the 50% tax band receives £1.50.
Pensions therefore remain an attractive way of saving for retirement. Watch our video ‘Why do I need a pension?’.
Are there any alternatives?
ISAs are the other great tax-efficient savings vehicle. While a pension gives you tax-relief on the way in, with an ISA you benefit on the way out, as returns on ISAs are tax free (with a pension you may be liable to pay tax when you start using drawing on it in retirement).
You can invest up to £10,200 in an ISA this tax year, of which up to £5,100 can be put into a cash ISA (the tax year runs until 5 April 2011). The annual allowance should then rise with inflation which will take it up to £10,460 for the 2011-2012 tax year.
For more information about ISAs, read our article ‘New ISA rules explained’.
When it comes to long-term saving, it is well worth taking advantage of pensions and ISAs as the tax benefits will really help boost the value of your investments.