The UKís radical pension reforms, set to be officially instigated from April 2015, will provide savers with the logistics to optimise the number of tax reliefs they receive and raise their pension pot contributions by a staggering 88% each year.
The measure is applicable to all types householdís with couples both aged higher than 55 years old and could raise their potential pension pot by 88% every year from now, whilst simultaneously putting themselves in line to raise it more via investment returns.
So, how does the pension loophole work?
In order to explain how to use the loophole, we will use the hypothetical case study of a married husband and wife. In this situation, the wife is paying 40% income tax, whilst the husband is unemployed. Both are 55 years old, and are seeking to bolster their pension pots through the use of the aforementioned tax relief technique.
The reality of their situation is that they- like anyone who makes pension payments ñ are entitled to receive tax relief on their contributions in accordance with the income tax rate they pay. It is worth remembering however, that even individuals who are unemployed, can obtain tax relief of 20% on their pension payments totalling £3,600 each year, though the doctrine is essentially the more you earn, the higher you stand to save.
Stage one ñ The husband contributes £3,000 in 2015 into their pension pot and tax relief means that this rises to around £3,800.
Stage two ñ The husband takes out the entire sum of his wifeís pension, including the money added on by the tax relief granted to his wife. The husband can do this straight away from April next year as the new pension reforms enable individuals to have greater flexibility when it comes to accessing their funds. In this scenario, the husband does not earn a yearly salary because he is unemployed, and thus the withdrawal he made from his wifeís pension pot would be not be taxed because it is lower than the annual personal allowance in the UK.
Stage three ñ The husband then gives the money from this withdrawal to their spouse, and no problems will arise from the taxman because the two share marriage tax benefits. The wife is then proactive and puts the money into her own pension pot, which subsequently receives the 20% tax relief and brings their total pension savings to a substantially higher £4,560. However, as she pays 40% on her income tax, she is entitled to ask for a total tax relief of 40% on her next tax return, which will see the number rise even further to over £5,300- representing over an 80% rise.
In the above example, the couple manages to achieve the maximum amount of tax relief. However, in householdís where there is only one breadwinner and they only pay 20%, a potential annual tax saving of 56% is achievable- a hugely beneficial reality to secure.
Is this technique legitimate?
As the new pension reforms are yet to be officially enacted, no final decision over their legitimacy has been made by the government. However, under existing regulations the technique is completely legitimate, and should be closely considered by anyone who aspires to have a useful and enhanced pension pot.
Evidently, the effectiveness of this measure would be substantially reduced if no one in your household is employed ñ including yourself – as you would be constricted to putting up to £3,600 a year into your pension pot and receiving 20% tax relief. However, if you are in a household where one member earns a large salary and the other is unemployed, tax relief as high as £2,500 could be attained each calendar tax year providing your situation remains stable and secure.
For those who are 55, that would provide you with an extra £25,000 in your pension pot by the time you reach your retirement age, and moreover you stand to make even more depending on the trajectory of your investments.
Ultimately, the allure of expanding your pension pot and securing your financial future should be the driving reasons behind considering this tax relief measure, though the reality that it can be done at the expense of the taxman is all the more reason to set the wheels in motion and start preparing for 2015.
How long can I utilise this technique?
Hargreaves Lansdown have suggested that the government might eventually decide to destroy usage of this loophole by introducing a life-spanning cap on the number of occasions that an individuals can invest and take out money from their pension pot after they have got to a specific age.
However, as with all loopholes, the lifespan of this measure is impossible to determine, and the government might decide to address its usage if it significantly impacts the Treasuryís revenue. It is likely that any action to stop this loophole being used would not be taken until at least the 2016 revenue figures are determined, which would mean that there is an opportunity for couples this year to capitalise on its existence and bolster their pension pots. The Treasury will then decide whether the technique of ërecyclingí tax reliefs is too detrimental to their overall intake.