Tax relief in SIPPs is more important than you might think
We all know that it is important to save for retirement, but few people think about the long-term gains from tax relief on pension contributions. Here we illustrate how tax relief, and saving for the long term could benefit your family.
The Brewin Dolphin Family Wealth Report, published last year, revealed that only 2% of individuals aged 55 and older would consider gifting their children money to top up their pension.
We think this is a mistake, and that those who can afford it should give it serious consideration.
While your children (and grandchildren) may not thank you now for your foresight, preferring instead the instant gratification of a gift, or perhaps an ISA top up, we see pensions as being an excellent way to pass on wealth in a tax efficient manner within the annual gift exemption for individuals of £3000 a year.
No matter your age, or whether you have no earnings, everyone is entitled to save up to £2880 a year in a self invested personal pension (SIPP), for which they receive additional tax relief of £720, making a total of £3600.
With the ISA limit having increased to a generous £20,000 (or £40,000 a couple), maximising contributions for yourself and your spouse is an option available only to the very wealthy, once allocations to personal pensions and general expenditure have been accounted for.
Parents and grandparents could boost their offspring’s pension pots
The importance of pension tax relief over a long period cannot be overstated — investment returns compounding over a long time are particularly valuable tools for wealth accumulation. The Barclays Equity Gilt Study shows that UK equities have produced an average ‘real’ (inflation-adjusted) return of 5.1% per year, compared with 1.2% for government bonds and just 0.8% for cash.
Using the historic 5.1% real return of UK equities, and a more conservative 3.5% rate, we can see in the two examples below what returns an investor might be able to achieve in their respective SIPPs.
A mother of three children takes ten years out of work between the ages of 30 and 39 to raise her children. Her parents pay £2880 (grossed up to £3600 with tax relief) a year into her SIPP on her behalf. She retires at 65.
A contribution of £28,800, with £7200 additional tax relief, could result in a SIPP worth £174,000 in today’s money at a growth rate of 5.1%, or £107,000 at the lower rate of 3.5%. Given that the average pension pot forecasted for an 18-44 year old is just £175,000, this would make a substantial boost to your quality of retirement.
Looking at the value of the tax relief alone, the growth of the £720 government top up could be worth as much as £34,800 by the age of 65 (higher than the cumulative payment of £28,800), or £21,400 at the lower real return of 3.5%.
The family of a new born baby fund a SIPP, paying in £2880 a year (grossed up to £3600) for 18 consecutive years.
For an outlay of £51,840, topped up by £14,760 of tax relief, the child could end up with a pension pot aged 65 of £1.17 million (exceeding the present lifetime pension cap of £1 million), or £475,000 at the lower growth rate of 3.5%.
Looking at the tax relief, the benefits are substantial, and over-time compounding has a greater opportunity to work its magic. Eighteen consecutive years of £720 tax relief with capital growth could result in a pension pot – just from the growth of the tax relief — of £234,000 or £95,000 at the lower rate.
We show these examples without the impact of platform costs or ETF fees (as low as 0.07% for a cheap FTSE 100 ETF), but the principal remains the same. Providing for your dependants can be done efficiently from a tax perspective, and the earlier they save, and the more tax relief they receive, the wealthier they should be.