Pensions: Top it up with the taxman's blessing

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The Independent Culture
Many, possibly most of us, are not saving enough to ensure that we have a comfortable retirement. Nor is membership of a company pension scheme a guarantee of a decent income after work. Richard Shackleton has some remedies.

For those who are making contributions into a pension scheme, the tax rules are very generous. Up to 15 per cent of salary, not including contributions by your employer, can be invested, with the contributions attracting full tax relief.

If you are a member of a company pension scheme and are worried about how much you will be entitled to when you retire, find out. You have the right to ask the trustees of the scheme for a free projection of your likely benefits. Most pension schemes will provide these figures once a year.

This will tell you whether you making sufficient contributions or should make further payments, called Additional Voluntary Contributions (AVCs), to increase your eventual pension entitlement.

All too often employees mistakenly believe that because contribution levels are set by the employer, they cannot be increased. In fact you should be able to make AVCs into the main pension scheme or one run alongside it. Alternatively, you can invest in free-standing AVCs (FSAVCs), usually arranged with an insurance company.

AVCs are usually very cheap, because your employer will often pay most or all of the administration expenses. They take little time to set up. FSAVCs are more expensive, so it pays to shop around, bearing in mind that you should also be prepared to compare performance. As with the contributions to the main pension scheme, AVCs attract tax relief at the individual's highest rate of income tax.

Payments into an AVC can be varied up to the overall 15 per cent limit for a pension scheme.

It is also possible for some AVC schemes to accept lump-sum payments (single premiums) in order to boost savings. So those in receipt of a big hefty annual bonus can then put it into their pension fund and still get full tax relief.

Many public sector schemes offer the chance to "buy back" contribution shortfalls from previous years. So a teacher aged 50, for example, earning pounds 28,500, buying two years over a 10-year term, will pay 4.24 per cent of salary, or pounds 100.60 per month. In return this will buy an extra pounds 712.50 of index-linked pension, with a half widow's pension.

Contributing an extra pounds 100 per month into an AVC with Equitable Life over the same period, assuming growth of 9 per cent per annum, would create a fund worth pounds 17,980. This could buy an index-linked pension today of pounds 763 per annum. Of course, there are no guarantees on fund performance or what pension it will buy at retirement.

It is possible to be caught in a tax trap by contributing too much. Overfunding a pension scheme means having too much money in an individual's fund to buy the maximum benefits permitted by the Inland Revenue. In a "final salary" scheme where the pension received is based on what was earned at or near retirement and length of scheme membership, the most the taxman allows is two-thirds of your pay.

If a pension scheme has been overfunded via FSAVCs, the investor will get the excess back accompanied by a heavy tax penalty of 35 per cent for basic-rate taxpayers. You have to declare that in a tax return and pay further tax, taking it up to 48 per cent for higher-rate payers. With in-house AVC schemes, any contribution level is tested at the point in which the contribution is made, so there is less likelihood that you will overfund the scheme.