Pension tax relief: the secret weapon to combat inflation

In a world of high inflation, low interest rates and stock market volatility, it can be perplexing to know how best to grow the value of your money. Katie Binns points to a less obvious but very powerful option.

Inflation is now at 6.2%, its highest level in 30 years. Its effect is especially acute on cash savings, where returns have been paltry for a few years and now trail a long way behind current consumer price inflation. 

Meanwhile, investors looking at a global stock market riddled with uncertainty have been forced to reassess whether their investments at the very least have a chance to keep pace with inflation.

However, there is one place to put your cash that gives an often-overlooked instant inflation counter-balance - and that’s your pension.

The reason pensions offer an instant antidote to inflation is tax relief. “Tax relief is the ‘secret sauce’ of pensions,” explains Becky O’Connor, head of savings and investing at interactive investor.

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​​​​How pension tax relief works

At its simplest, you contribute to a pension and you don’t pay income tax on that contribution. However, this somewhat undersells the benefit. “The impact of tax relief is nothing short of one of the miracles of modern saving,” says O’Connor.

“It magically and instantly adds a ‘return’ to your own contribution that is not from interest or investment growth, but from tax you don’t have to pay on that contribution - which you would have to pay if you put it in an ISA or savings account.”

Got that? We’re talking about an on-the-spot return on your money – before investment growth and compound interest get a look-in.

If you’re a basic-rate taxpayer, a £100 contribution requires a personal contribution from you of £80, with £20 from tax relief – that’s like getting an extra 25% ‘return’ on your initial contribution from the government straight away. 

The effect is even greater if you’re a higher-rate taxpayer. A £100 contribution requires £60 from you, with the remaining £40 coming from tax relief – that’s an immediate 67% ‘return’ on your initial contribution.

An on-the-spot return for higher-rate taxpayers

We’ve done the maths to highlight what this return looks like in pounds and pence for higher-rate taxpayers.

If you earn £55,000 annually, an 8% pension contribution over one year is £4,400.Yet tax relief and an employer contribution of 3% mean the personal contribution you make is just £1,650.

With tax relief added - a tidy £1,100 - your contribution rises to £2,750. That £1,100 in tax relief is 67% of your personal contribution, a huge instant boost if you’re trying to make your money beat inflation.

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For someone earning £80,000 annually, an 8% pension contribution is £6,400. Take away the tax relief and an employer contribution of 3% and the personal contribution is just £2,400. With tax relief added, an instant return of £1,600 tops up that contribution to £4,000. Again, as a percentage of the personal contribution, this £1,600 tax relief is 67%.

“In the current market, you’d be hard-pressed to find another investment that offers such an uplift for nothing. It’s free money,” says O’Connor.

And if you happen also to invest in something that generates decent growth within your pension – so much the better, as this is tax-free growth. “That free money is being spun into more money, adding even more value to your funds,” adds O’Connor.

It’s smart to take advantage of this tax relief over the years when you can afford to do so, and while they are available. This way, you also benefit from the powerful impact of compound growth – or earning returns on your returns – to help outpace inflation.

Everything has a price tag

You will need to lock up your money until you are 55 (or 57 from 2028) in return for this amazing benefit – but if you don’t need it sooner, that price is well worth paying.

How much extra you can put in your pension will depend on your current cash flow needs and investment preferences. With so many cost of living rises and competing priorities, you may want to carefully go over how you can balance debt, saving and investing.

Interactive investor has an award-winning, low-cost Self-Invested Personal Pension (SIPP)