Key Post Should a spouse paying 20% tax make pension contributions?

RedOnion

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Copied from another thread as it's a general issue which applies to a lot of people and I have not seen it teased out systematically - Brendan

Edited because I got the tax treatment for a married couple in retirement completely wrong - Red


So I thought I read making contributions to a pension with a 20% tax relief wasn't a great idea but maybe I am mistaken?
You might well have read it, but that's just someone's opinion! :)

Not everyone will agree with me, but I think it makes perfect sense. I don't understand why people think getting 40% relief and paying 20% or 40% on drawdown is fine, but getting 20% relief and drawing down tax free doesn't? and drawing down tax free lump sum and balance at 20% doesn't?
(Edit: Corrected as I made the error of applying a single persons tax treatment to a married couple. Assuming there is an entitlement to state pension, the tax free allowance will be used up and any remaining personal tax credit utilised by the other spouse)

Unless something goes wrong, you will be paying higher rate in retirement. And your spouse has her own tax bands in retirement that possibly won't be used. So she could pay into pension now; get 20% relief, with gross roll-up inside the pension wrapper. Take out 25% tax free on retirement, and draw down the remainder at lower tax rate in retirement.

Scenario here is that first spouse is higher rate tax payer with a well funded pension. 2nd spouse is lower rate tax payer. There is free cash flow without another use, so would otherwise be invested outside of a pension wrapper. 20+ years to retirement.

With 20 years to retirement, the real benefit is not really the 20% tax relief now, but the gross roll-up within the pension wrapper.

Arguments against contributing at lower rate relief:
1. Spouse might become a higher rate tax payer later, so should wait until then to make pension contributions. I don't think this changes the case for contributing; it's the marginal tax rate in retirement that matters.
2. You die, so spouse ends up paying higher tax rate in retirement.
3. There is other income outside of pension, so the marginal tax rate in retirement is at higher rate.
4. You're locking away the money long term but you might need it for something else before retirement.

Previous thread that teased out some ideas on this.
 
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Brendan Burgess

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How does tax relief on pensions work for spouses

Take this example:
He is earning €100k
She is earning €20k
She is aged 50

Their 20% tax band increases by €26,300 for her income.

So, she is being taxed at 20%.

She can contribute €6,000 a year and she gets the tax relief at 20%, so it costs her €4,800 net to make the contribution.

If her income is €30,000 and she contributes €9,000
She gets tax relief on €3,700 @40%
And €5,300 at 20%
 
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Brendan Burgess

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Hi Red

If you are paying 40% tax now and you contribute to a pension, you can get 25% of your pension fund tax-free on retirement, so that means, in simple terms, you are reducing your tax rate to 30% (+ gross roll up)

If you are paying only 20% tax, and you end up paying 20% in retirement, you will be reducing your tax rate from 20% to 15%. I just don't know if that is worth it.

  • You are tying up the money until retirement
  • You are getting tax relief within the fund, but this is probably cancelled out by high pension fund charges
If you are close to retirement, then it's definitely worth it:
  • You are not tying up the money for long
  • You probably have visibility on your earnings in retirement and know that you won't be paying 40% tax on the drawdown.
If you are in your thirties or forties, you probably have better things to do with your money.
  • Keeping it outside a pension scheme is much more flexible
  • If you have a mortgage or other borrowings, you should be clearing that first
But most of all, you can save your money outside your pension fund so that if you later move into the top bracket, you can then contribute it and get 40% tax relief instead of 20%.

And "save your money" would include paying down your mortgage. If you have no mortgage later in life when you are paying 40% tax, then you will have much more scope to max your AVCs at that stage.

Brendan
 

RedOnion

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If you are paying only 20% tax, and you end up paying 20% in retirement, you will be reducing your tax rate from 20% to 15%. I just don't know if that is worth it.
Brendan, just to tease this out a bit.

Is your starting position that a lower rate tax payer probably shouldn't contribute to a pension beyond enough to get matching contributions from their employer (regardless of the original scenario with a spouse?)
 

Brendan Burgess

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Close to retirement, when the benefit is immediately visible and the money is tied up for only a short time, I think that they should be made.

But I don't think that they should stash away their money in an untouchable pension when they are in their 30s or 40s.

Brendan
 
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