Deadline looms for pensions ploy

By JUSTIN HARPER FOR MAILONLINE
Updated:

 

A LITTLE KNOWN pensions trick called immediate vesting can earn you free cash from the Inland Revenue. But you have only a few weeks left to take advantage of it in this tax year.

Most people are allowed to invest up to £3,600 each tax year into a stakeholder pension. Thanks to pension tax rules, this does not all have to be your own money.

You need to shell out £2,808, which is topped up by basic tax relief at 22%, worth £792. You can have this top-up even if you do not pay any income tax.

If you are a higher-rate taxpayer, you get £1,440 in tax relief - 40% of the £3,600. The basic rate relief of £792 is paid into the pension but you need to claim the remaining £648 back through your tax return.

This is only the beginning. As soon as the £3,600 pension is set up, you immediately take out the allowed 25% tax-free lump sum - £900. Then you use the remaining £2,700 to buy an annuity, which is a guaranteed income for life. This tactic is known as immediate vesting because, in effect, you get an instant pension.

How much pension? A £2,700 sum would buy a 65-year-old man an annuity from Standard Life of £156 a year. Annuity rates depend on age and gender. For a woman of 65, Standard would pay £142 annual income.

Complicated? Yes, but the return you get is attractive. For a top-rate taxpayer, the net outlay comes down to only £1,260 (£3,600 less £900 lump sum cash back, and £1,440 tax relief).

This £1,260 gets you an annual income of £156 gross. Deduct top-rate tax, and the income is £93.60. This is a 7.4% net return on your capital - not bad for a day's work. The net investment for a basic-rate taxpayer is £1,908. For this you get £121.68 a year net - a 6.4% return.

Immediate vesting can only be done once in a tax year but you can do it every tax year if you wish. Tom McPhail, at adviser Hargreaves Lansdown, said: 'For a higher-rate taxpayer, immediate vesting is definitely a good call but it is marginal for a basic-rate taxpayer. You are sacrificing capital by locking into a certain income but the tax breaks speak for themselves.'

Not all insurers will accept small pension pots. For some, the minimum is £10,000. But Standard Life and Legal & General have packages set up to let you vest immediately. This can be done with any personal, stakeholder or self-invested personal pension. For those who do not work or pay tax, a stakeholder pension is the only way to obtain the perk.

You have to be at least 50 to use it. The older you are, the better the annuity rate will be. But you cannot do it if you are in an occupational pensions scheme earning more than £30,000 a year.

Most watched Money videos