For example, a higher rate taxpaying employee receives an annual employer pension contribution of £40,000. After deduction of employer NI at 13.8 per cent, that would equate to additional salary of £35,149.
But of course, the employee then has both income tax and NI to pay on the additional salary, so the amount they will actually receive would be £20,386.
The table below shows what the employee might get back by investing the net pay of £20,386 over five years into another investment wrapper with the same gross roll-up and achieving a 2.5 per cent real rate of return. Of course, the net pay is greater than the current Isa allowance, but this could still be achieved by spreading across the tax year or using their spouse’s allowance.
| Pension | Isa | Offshore bond | |
| Future value | £45,256 | £23,065 | £23,065 |
| Higher rate taxpayer in retirement | £20,365* | £23,065 | £21,994 |
| Basic rate taxpayer in retirement | £27,154** | £23,065 | £22,530 |
* After LTA charge at 55 per cent (which also equates to LTA charge of 25 per cent + 40 per cent income tax if taken as income)
** After LTA charge of 25 per cent plus 20 per cent income tax on balance
No alternative but to give up personal funding? Think again
There is something that feels slightly uncomfortable about paying personal contributions knowing that an additional tax charge will be applied. What really matters, though, is what you might get back after all taxes have been deducted.
And that will depend upon the tax rate paid in retirement. If income in retirement can be kept at basic rate, personal contributions receiving 40 per cent tax relief even after the LTA charge will achieve exactly the same return as an Isa.
The table below compares what the client might get back in their hand assuming a real rate of return of 2.5 per cent over 10 years for the same net cost of £15,000.
| Individuals | Sipp | Isa | Offshore bond |
| Contributions | £25,000 | £15,000 | £15,000 |
| Fund value | £32,000 | £19,200 | £19,200 |
| LTA charge 25% | (£8,000) | ||
| Income tax 20% | (£4,800) | (£840) | |
| Net amount in hand | (£19,200) | £19,200 | £18, 360 |
And of course, this ignores the position on death with the pension generally being IHT free, whereas both the Isa and offshore bond will form part of the estate for IHT.
It is only natural to think tax charges should be avoided – especially one designed to act as a cap on funding. But it is always important to weigh up all of the options available. And the alternatives will generally have their own tax consequences to be worked through. But do not immediately dismiss the option to ‘do nothing’ and carry on regardless, as it could give the best outcome.
