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Tax free cash and equity


Responding to an article by economist Dr Tim Leunig, the FT published a letterfrom Stuart explaining why the maths of saving in or out of pension accounts require less than 100% of the money in a pension to be converted from capital to taxable income to equalise the two streams. If the 25% tax free cash was removed, the choice of pension would have been, with hindsight, irrational. That also means that for the Government to remove it would be immoral, exploiting the fact that the money is already trapped in a pension. A brief extract explains the essential principle:

“HMRC gives tax relief when pension contributions are made and allows pension capital to grow tax free but then recovers the tax revenue foregone by levying income tax on the stream of payments made when the pension capital is eventually withdrawn. If you retire on capital saved outside a pension scheme, you will have less capital but it will be very lightly taxed. If you retire on capital saved inside a pension scheme, you will have more capital but most of it will be taxed as if it were income, even though it is only your capital coming back. There is some proportion of the pension capital subjected to this conversion to taxable income at which the two forms of saving are roughly equal in terms of the present value of after-tax amounts. For high earners, that proportion works out as about 75%. So, with 25% tax free cash, there is equity between different generations of taxpayers.”

The effect of the conversion of pension capital to taxable income (which is what ensures the next generation gets a a ‘dividend’ for providing tax relief at the point of saving) often gets overlooked when making savings choices, including by many accountants and financial advisers. The maths favour pensions clearly only where there is a lower expected tax rate in retirement than in employment – something you will not be sure of when making the choice.

#pensions #taxfreecash #taxation

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