Right now, it feels like every day comes with a new warning about the rising cost of living. As well as getting used to general inflation, we now have to contend with an energy pricing crisis, upcoming National Insurances rises and the prospect of more expensive council tax bills.

So with expenditure on the up, our attention naturally turns to where we can make savings. Well, as the saying goes, there is no such thing as a free lunch, or is there?

With all the complexity and jargon surrounding pensions, it is easy to lose sight of the simple appeal of these vehicles. Their attraction lies in the generous tax savings, making them one of the most efficient means of saving for retirement. Plus, the advantages do not end when you reach retirement.

Tax relief on contributions

Can you imagine the impact if Amazon said to its customers, for every £80 you spend with us, we will top it up by £20. People would be charging through the virtual store doors. Well, in essence, that is the offer to retirement savers from the government.

They will increase pension contributions by an amount equivalent to the basic rate of income tax, currently 20%. If you are fortunate enough to be in the earning bracket where the higher rate of tax applies, you can secure an additional 20%. This doubles the government contribution in this example from £20 to £40.

So if you are a higher-rate taxpayer investing £10,000 in a calendar year, the government will contribute £4,000 towards that. The relief on contributions even extends to the highest earners in the UK who are subject to 45% tax on earnings over £150,000. That may be the closest thing to free money you can get.

Tax-free returns       

The returns from many forms of investment are subject to tax. The two most common being income tax on dividends and capital gains tax on capital growth

Fortunately, in approved private pension arrangements, the growth is not subject to these taxes. Where investors really benefit from this is the additional returns on that saving over the long term.

If a pension fund grew by £10,000 during a year and that growth was subject to a £2,000 tax charge, the net return would fall to £8,000. But the loss suffered is not limited to the £2,000. It extends to the loss of future returns on that £2,000 over the lifetime of the investment.

As pensions are primarily about the long term, investors significantly benefit from avoiding this tax deduction and the future returns on that saving.

Salary Sacrifice

Trust me, it’s better than it sounds.

Employers are free to contribute to your pension plan instead of salary, subject to certain limits. Whilst this reduces your take-home pay, it is still an interesting option. It really comes into its own for bonuses, which are not required to support day-to-day expenditure. If your employment includes the payment of a bonus, you could sacrifice all or part of that in favour of a contribution to your pension.

As a consequence, you would not pay income tax or national insurance on that bonus. If the bonus were to result in your total earnings being over the band for basic rate tax, £37,700, this could also mean you avoid paying tax at the higher rate. For those earning close to or over £100,000 a year, it can also ensure they retain their full personal allowance, which provides for a level of earnings without tax. 

Tax-free cash

For those reaching retirement, the good news is that the HMRC is still pretty generous. You can walk away with 25% of the value of your pension plan without paying tax.

This is particularly appealing to those with planned lump-sum expenditures, like paying off mortgages, new cars or a holiday of a lifetime.

Legacy free from Inheritance Tax

In the event of your death, the value of your pension pot can pass to your nominated beneficiary without any reduction for Inheritance Tax. This is a saving of 40% or, to put it in number terms, a plan worth £400,000 would save a considerable £160,000.

If the pension holder was under 75 at the date of death, the recipient can take the whole lump sum or receive the money in instalments without income tax being deducted. If the investor was over 75 then income tax is applied at their marginal rate on any withdrawals.

So whilst times might be getting tougher, there are still some ways to optimise your savings and make a real difference to long-term investment planning. Pension plans offer a series of attractive benefits, and it is well worth taking advice to ensure you are making the most of the opportunities.

Important Information

The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment decisions. Please also note the value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.