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It is the tax treatment of pensions that makes them both an attractive long-term savings option, and a complicated one. Here Adrian Lowery, personal finance expert at Isa and Sipp platform Bestinvest, delves into ten of the tax benefits and dangers pension savers need to know about along with Louise Higham, a chartered financial planner at Tilney, Smith & Williamson.
‘It pays to know about how pensions are treated by the taxman right through the saving journey and beyond retirement,’ says Lowery. ‘Not least because if the UK’s public finances don’t improve then some of the tax reliefs may well be diluted in the future – just as personal allowances have been eroded and frozen in recent years.’
Tax relief boosts the value of your pension pot immediately, so cannot be ignored.
At some companies the tax benefits could be even greater as they may allow employees to reduce salary or bonus payments in lieu of increased pension contributions .
Savers who are able to lock away their money until the minimum pension access age (currently 55) need to seriously consider the fiscal advantages detailed above. But there are ceilings on what can be saved tax-free.
For most people the total sum of personal contributions, employer contributions and government tax relief received can’t exceed the annual personal allowance of £40,000 (2021/22). More rigid and complicated rules apply for the very highest earners under a tapering allowance that can reduce the annual allowance to as little as £10,000.
‘And you can’t contribute more than 100 per cent of your earnings to a pension during the tax year, so if your salary is lower than £40,000 then you are limited to contributing your annual earnings into pensions,’ says Higham.
‘Meanwhile the Lifetime Allowance (LTA) is the limit on how much you can build up in pension benefits over your lifetime while still enjoying the full tax benefits. Exceeding the standard LTA of £1,073,100 (as of 2021/22 – and frozen at that level until 2025/26), will lead to additional tax charges on the excess when you come to take your pension benefits or turn 75.’
The pension annual allowance was £255,000 in 2010/11: as it is now £40,000, it is affecting a lot more savers than it used to.
Pensions ‘carry’ forward’ rules allow you to use unused allowances from up to the three prior tax years in the current tax year – provided you have already maximised your current annual allowance and were a member of a pension scheme in the tax year you are carrying forward from.
Notionally, you could potentially carry forward up to £120,000 of unused allowances and add them to this year’s £40,000 allowance. Tax relief would be applied at your current marginal rate and so carry forward can be particularly attractive to someone whose earnings have risen significantly.
‘It is worth noting that you are still limited to 100% of your salary in the tax year you are making the contribution, regardless of how much you have available from previous allowances,’ says Higham.
The major drawback of pensions for some savers is that the money is locked away once committed. But up to 25% of your pot can be accessed tax free – with the remaining 75% available as taxable income – from private pension access age. That is currently 55, but set to rise to 57 from 2028.
This is certainly not to say that this is the right thing to do. But for savers aged 50 and over, the limits on access become less meaningful compared to the money benefits of saving into a pension.
Reforms introduce in 2015 – dubbed ‘pensions freedoms’ – mean today’s pension savers are no longer shoe-horned into buying an annuity with their pensions and have much greater flexibility in how they access their pension pots. But those planning to access their pension flexibly, either this tax year or next, need to think carefully about both the tax impact and the effect it will have on their ability to save further amounts into pensions in the future.
Anyone who makes a flexible withdrawal from their retirement pot beyond the 25 per cent tax-free lump sum triggers the ‘money purchase annual allowance’. This permanently slashes their annual allowance from £40,000 to just £4,000, and revokes the privilege to carry forward unused allowances from previous tax years.
This measure was introduced to stop people recycling money through pensions to benefit from extra tax-free cash.
When you take a flexible payment from your pension, HMRC assumes it is just the first of 12 monthly withdrawals. As a result this first flexible withdrawal from your pot is likely to be taxed at an emergency rate and will probably mean you are significantly overtaxed, potentially to the tune of thousands of pounds.
To get this money back you can do it through your self-assessment tax return, or by applying by form to HMRC:
If you or your partner have registered for and claim child benefit, and one of you earns more than £50,000 a year, you’ll be liable for the high-income child benefit tax charge. This can be a major irritation for some couples as it needs to be paid through self-assessment.
The charge increases gradually depending on how much you earn. For those earning £60,000 or more, it equals the total amount of the child benefit.
This means lots of people choose not to claim child benefit – but by not claiming, you or your partner might miss out on National Insurance credits that count towards state pension entitlement.
‘Therefore, if you are affected, the sensible option is to register for child benefit but opt to not receive it. So you don’t have to pay the tax charge but still accumulate NI credits,’ says Higham.
‘This tax charge could also be avoided – while still legitimately claiming child benefit – if by using salary sacrifice for your pension contributions you take your gross earnings below the £50,000 threshold.’
Pensions are an important part of tax and inheritance planning.
If you die before age 75 your fund can be passed on to your beneficiary tax-free, while if you die after 75 it is taxed in the same way as income when your beneficiary draws an income. Furthermore, if your beneficiary dies before age 75 they too can pass on any untouched funds tax-free – even if you died after age 75.
Therefore, it’s essential that you arrange for your pension to go where you want it to – particularly as this can change according to your family circumstances.
‘If no death benefit nomination is completed then your beneficiaries would only be able to receive your pension benefits as a lump sum,’ says Higham.
‘This can lead to quite a significant tax charge for your loved ones if anything happens to you after age 75. By completing a nomination form your loved ones will have options to take the pension to ensure this is taken as tax efficiently as possible based on their circumstances at the time.
‘Nominating a pension beneficiary is usually something that can be done in a matter of seconds online and can result in a massive tax saving for your loved ones.’
Even savers without earned income who don’t pay tax – such as a spouse who isn’t employed or children – can still pay into a pension and receive 20% tax relief. In this case, the ceiling on annual pension saving is £3,600, made up of your contribution of £2,880 and the taxman’s contribution of £720.
This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.