This article was last updated on 04/10/2022
On 23 September, Chancellor Kwasi Kwarteng dropped quite a bombshell with his not-so-Mini-Budget, shaking up the tax rules for millions in Britain. Behind the headline figures sit some need-to-know hidden effects on our pension savings and pension incomes.
1. Lower income tax rates means less in your pension
From April 2023, income tax rates will change. While this will have a positive effect on take home pay, it will have negative effects on pension saving.
The basic rate of income tax (on earnings between £12,571 and £50,270) will be cut from 20% to 19% from April 2023.
According to HMRC, these are the changes we can expect to see in real terms. The reduction in income tax to 19% in 2023 will mean 31 million basic rate taxpayers will benefit with an average gain of £170 in 2023/24. Those in the higher rate, and additional rate tax band will benefit from an average gain of £360. This impacts pension savings because pension tax relief - the bonus pension savers usually receive from HMRC on their personal pension contributions - is added on at the marginal rate of tax. So when the rate of income tax falls, so does the amount of tax relief on pensions.
It looked as though the 45% additional rate of income tax (on earnings above £150,000) was going to be scrapped altogether, falling to the next bracket at 40%. However, 10 days after the announcement on 23 September, the government made a u-turn, deciding not to proceed with cutting the additional rate of tax for the UK’s highest earners.
What does this mean for me?
For most basic rate taxpayers this means that the tax top up they’ll get on their pension contributions will fall from 25% to around 23%.
In real terms, this means from April 2023 a basic rate taxpayer would have to make an £81 contribution to get £20 in tax relief from HMRC, so £100 goes into their pension. Before the changes, they would only need to pay £80 into their pension to get the extra £20 in tax relief.
Relief at source
For basic rate taxpayers saving in ‘relief at source‘ (RAS) pension schemes - where basic rate tax relief is added automatically - there will be an extra year during which they can continue to receive tax relief at 20%. Here at PensionBee, we use ‘relief at source’, meaning our customers will benefit from this additional year of tax relief at 20%.
It’s less clear for those in ‘net pay’ pension schemes - where contributions come straight from pre-tax pay - but they’ll presumably receive 19% tax relief from April 2023 onwards.
“Maintaining a one-year transitional period for pension savers to continue to claim tax relief at 20% on contributions, should make pension contributions more affordable.” – Romi Savova, CEO of PensionBee
Pension carry forward rule
Pension savers can also use carry forward to make the most of their contributions. Under the current rules, most savers can contribute up to £40,000 to their pension each year and receive tax relief. If you reach the £40,000 allowance in one year, you can carry forward any unused annual allowances from the past three years.
It’s important to be mindful that, with the carry forward rule, you can’t claim tax relief on contributions in excess of your earnings in any tax year.
2. Lower pension contributions could mean a smaller pot and less retirement income
Changes to income tax rates that result in lower pension contributions (as explained above) will result in smaller pension pots, and less retirement income over time. This is because of the power of compound interest, where long-term incremental investments snowball over time, with growth building on growth.
What does this mean for me?
Calculations by Scott Gallacher, an Independent Financial Adviser, take the example of a 40 year old basic rate taxpayer earning £40,000 a year and contributing 10% of their net pay to a defined contribution pension. They’re likely to find their pot will be worth £1,465 less in today’s money at age 65, as a result of the announced reduction in tax relief.
For those who are younger, with longer to save, the impact is even greater. Someone aged 22 on a salary of £40,000 and just starting to save into their pension - also paying in 10% - would see their pot hit by around £2,229 in today’s money.
However, this doesn’t have to be the case. In order to avoid a reduction in your pension pot and retirement income, savers may wish to consider contributing more to their pensions where possible. In the current cost of living crisis, this is likely to prove difficult for many, but those who are able to, may want to consider using the money saved by paying less income tax to boost their pension contributions.
“The measures introduced make the cost of living more affordable for many, including keeping savers on track with pension contributions, when they previously may have considered pausing their contributions or opting out of workplace pension schemes.” – Romi Savova, CEO of PensionBee
3. ISAs may look more attractive
The benefits of tax relief make pension contributions a great way to save and invest for the long term. The same is true of ISAs, which also grow free of tax. Money withdrawn from ISAs is also tax-free, making them an attractive addition to pension plans.
What does this mean for me?
For basic-rate taxpayers, the cut in tax relief to 19% will mean Lifetime ISAs (LISAs), which continue to offer a savings bonus equivalent to 20% tax relief, will become more attractive. Anyone aged 18-39 can open a LISA and use it to buy their first home, or withdraw it as part of pension savings from age 60.
The Bank of England increased interest rates by 0.5% to 2.25% on 22 September, the highest level since 2008, with three monetary policy committee members voting for a larger hike of 0.75% that could still arrive in November. At the time of writing, The Bank of England have responded to the crash in the Pound by saying they won’t hesitate to change interest rates as and when needed.
The £45 billion of government borrowing to pay for the tax cuts in the Mini-Budget could push interest rates up even further. Higher interest rates will mean many savers face paying income tax on their savings for the first time in over 10 years.
With best buy savings rates now above 3%, it’s a real possibility a basic rate taxpayer with £30,000 of savings will start to pay income tax on the interest they earn above the £1,000 personal savings allowance – unless that money is invested using an ISA.
For higher rate taxpayers the allowance is halved, so only the first £500 of interest is free of income tax. The ISA allowance means every adult can save £20,000 each year without paying tax on the gains.
4. Dividend income boost
Self-employed company directors, who mainly pay themselves in dividends, and investors who invest in dividend paying companies outside of their pension or ISA, both received a boost in the Mini-Budget, as dividend tax cuts were announced.
The highest rate of dividend tax will be cut from 39.35% to 32.5% from April 2023. The 1.25% surcharge on all dividend rates will also be scrapped from 2023/24. In particular, given the self-employed typically have less saved into their pension, this tax cut could be an opportunity to help them to save more.
What does this mean for me?
For those living on and saving from dividend income (in addition to salary and pension income), the Mini-Budget changes give a boost.
Abolishing the highest rate of dividend tax will only benefit those earning over £150,000 a year, who’ll see their dividend tax rate cut from 39.35% this year to 32.50% next year. This represents an 18% reduction in the rate of tax these investors and company directors will pay.
More widely, company directors, including the self-employed and contractors, who pay themselves via company dividends in addition to salary, will benefit from the tax cuts. Someone receiving £40,000 of dividends a year will save £475 as a higher-rate taxpayer, and £2,603 as an additional rate taxpayer in 2023/24 (compared to this tax year), according to calculations by Scott Gallacher, an Independent Financial Adviser. For basic rate taxpayers, the saving is up to £349.
Those taking £10,000 of dividends a year will be better off by up to £100 for basic rate and higher rate taxpayers, and £548 for additional tax rate payers.
Retail investors outside a pension or ISA - individuals who buy and sell through a brokerage firm or savings account - will see a lower tax bill if their dividends are over the annual dividend allowance of £2,000. To be in that position, they would have to have a portfolio of over £50,000 if it was yielding 4% a year.
Laura Miller is a freelance financial journalist.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.