Could you make £5,000 from pensions loophole?


George Osborne

A loophole in the new pension rules announced by George Osborne during the Budget means that once they kick in fully, anyone over the age of 55 and still in work could be thousands of pounds better off. The quirk has arisen because anyone over the age of 55 will be able to withdraw whatever they like from their pension - at any time they like - as long as they pay income tax on the money they take. It means the over 55s could start using pensions as current accounts, and save a fortune.

So can you take advantage?

The loophole

The loophole works though something known as salary sacrifice. Here you agree to formally reduce your salary, and have the same amount paid into your pension instead. This means you save tax at your marginal rate (anything up to 45%) plus national insurance at 12% on any of the salary you sacrifice and take as pension contributions. Meanwhile, your employer saves national insurance at 13.8%.

If you have a defined benefit salary this isn't going to work, because you will reduce the salary on which your pension is based. However, if you have a defined contribution scheme, you could take as little salary as possible (down to the minimum wage) and the rest in pension contributions: the Daily Telegraph has calculated that in this way you could save £5,000 a year.

This loophole was always technically possible, but in order to take advantage you'd have to be able to to live off the vastly reduced sum you were taking as a salary - or have enough in the pension pot to draw some down within the rules. This means there were only a limited number who were able to exploit it.

Under the new rules, people will be able to withdraw any money they need from their pension from the age of 55, so they could save the tax and national insurance on anything they pay into a pension, and only pay the tax when they withdraw it to spend - which means they save at least the 12% national insurance.

Can you take advantage?

You will need your employer on-side, because not every business has the flexibility or willingness to employ salary sacrifice on a one-off basis.

Even with their agreement, you'll have to wait for the rules to be fully operational before you can cash in.

Unfortunately, there is a strong chance that now the government has spotted the loophole, it will take steps to close it before the rules kick in. Money Marketing magazine has suggested that if everyone took advantage of the loophole, it would cost the Treasury £20 billion - so it's not going to leave the loophole in place. It added that one option would be to remove or reduce the tax-free lump sum people can take from their pension - to make pension saving less attractive.

The Telegraph suggested that the Treasury could make national insurance payable on pension contributions - which would have a wider impact on those who weren't using salary sacrifice. Alternatively, they could stop people paying any more into their pension once they have started withdrawing cash from it.

Tom McPhail, head of pensions research at Hargreaves Lansdown told AOL there may be another solution: "The short term fix is to ensure that such activity is brought within tax avoidance legislation: a cliff edge drop in earnings coupled with a commensurate increase in pension contributions at age 55 should be fairly easy for tax inspectors to spot. The longer term fix is a re-examination of the tax treatment of pensions and pension contribution allowances. There is a case for a sober review of pension tax breaks, once the current reforms have been implemented, if possible involving cross-party debate."

However, he emphasises that: "Knee-jerk solutions rarely stand the test of time, so such important changes should only be made if they can be proven to produce better retirement saving outcomes."

It's not clear which option the government will select, but the experts agree that they will clamp down as soon as possible - which could stop the majority of people taking advantage.

Fortunately, if you are over 60 and still in work, you don't have to wait for the new rules to take advantage, because rules that allowed the over 60s to cash in three pots of £10,000 kicked in immediately after the Budget. It means they can slash their salary through salary sacrifice, take large sums as pension contributions, and withdraw £10,000 of it at a time - saving national insurance.

For everyone else, the experts highlight that higher rate taxpayers should still be focused on saving as much as possible into their pension at the moment. They point out that there are still rumours that higher-rate tax-relief could be cut on pension contributions, so those earning above the threshold should put as much aside as they can afford before the rules change.

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