Pushing pensions to the limit

I continue to find pension wrappers are a powerful tool for building FIRE wealth quickly.  Let me demonstrate with a couple of quick examples:

• Over my FIRE journey I am fortunate to have found ways to earn more which means that I am today a 45% additional rate tax payer.  On top of that I also have to pay 2% employee national insurance on the last of my earnings.  This means that if I earn £10 and I don’t salary sacrifice it into a pension wrapper I only end up with £5.30 to invest.
• My employer allows pension salary sacrifice, has a contribution match up to a certain percentage and also gives me 10% of the 13.8% employer National Insurance that they save when I contribute to the company pension.  So under these conditions if I put that same £10 into the company pension I actually end up with £21 to invest.  That’s nearly 4 times more.
• Even if I continue to contribute to the pension wrapper once the employer match is over its still favourable.  In that instance I still end up with £11 going into the pension which is more than 2 times the savings outside of the pension.

The wise among you will now being saying ‘but pensions are just a tax deferral scheme’ and that’s certainly true but let’s look at how that will play out in FIRE.  The UK in my view can almost be considered a tax haven for those with enough wealth that work is not required.  To demonstrate let’s take £20,000 from that pension pot every year.  The 25% pension tax free lump sum effectively gives one £5,000 tax free.  Then one also gets a 0% tax rate from the £11,000 Personal Allowance leaving just £4,000 subject to 20% Basic Rate tax.  That works out to be an effective rate of tax on the £20,000 of just 4.0%.

Move to the Mediterranean and it could be even more favourable.  Cyprus, for example, gives a choice of how pensions can be taxed.  The first is 0% tax until you earn EUR19,500 with the next band being 20%.  In this example our £20,000 (assumed to be EUR22,460) sees an effective tax rate of just 2.6%!  The other method favours high pension sums as the income is taxed at the flat rate of 5% on amounts over EUR3,420.  In this example one’s effective tax rate would be 4.2% so one would pick the former in this example.

So if I don’t save into the company pension I’m effectively taxed at 47% and if I do I could be taxed at rates as low as 2.6%.  Of course there will also be some taxes on the non-pension choice but this just makes the pension even more favourable.

In exchange for these benefits one can’t access the wealth until aged 55 (which could well become a higher number) meaning one would need wealth outside of the pension wrapper to cover costs until private pension age (today I have 55% of my wealth outside pension wrappers).  Additionally, one is also subjected to a myriad of pension rules and regulations that are constantly being changed by government.  Let’s look at how a couple of those are affecting me at the back end of my FIRE journey.

The first is what is called the contribution Annual Allowance.  This is the limit that one can save into pension wrappers each year and still receive tax relief on the way in.  In the 2016/17 tax year the annual allowance is £40,000.  That’s a lot of money but further consideration is needed as nothing with pensions is straight forward.  If one is fortunate enough to earn ‘adjusted income’ of over £150,000 per year one loses £1 of annual allowance for every £2 of ‘adjusted income’ until the ‘adjusted income’ is £210,000.  By that time one’s annual allowance is down to £10,000.  ‘Adjusted income’ includes all investment ‘income’ and all pension contributions so it doubly affects me (work income and investment ‘income’).

To help with some of the damage I’ve so far been using a favourable rule called Carry Forward.  This allows one to add unused contribution annual allowance from the three previous tax years to the current annual allowance.  It’s important to remember when considering carry forward that the allowance was actually £50,000 in 2013/14, was £40,000 in 2014/15 and while theoretically was £40,000 in 2015/16 government tinkering could mean it’s actually a lot more.

So what pension changes is this forcing me to make now?  My carry forward is fast running out and so working on the assumption that I FIRE no later than September of 2017 I need to reduce my pension contributions by 25% which will hit my savings rate from here on in.  Not ideal but the impact is lessened because of the relatively short time until I won’t have to worry about it anymore as I’ll be FIRE’d.

The third rule is what’s called the Lifetime Allowance (LTA) which is a limit on the amount of pension income that can be taken from one’s pensions without incurring extra tax charges.  In 2016/17 the lifetime allowance is £1 million, in 2017/18 it stays at £1 million and from then on it is supposed to increase with ‘inflation’ (in my planning I’ve assumed government will choose the less favourable CPI).

It sounds like a lot of money but when you consider a FIRE’ee could have 10 or 20 years of compound growth before they can access their pension it’s something to watch.  The table below simulates what my pension wealth could be at the point I can access my pension.

Click to enlarge, My pension value simulation which could impact my lifetime allowance

That’s starting to get a little too close for comfort even after reducing pension contributions.

It looks like if I FIRE no later than September 2017 I’ve timed me pension contributions pretty well meaning I’ve avoided about as much tax as possible through the use of pensions.

As always DYOR.