Pensions and tax
One of the primary reasons to invest in a pension for your retirement is the fact that governments want to incentivise retirement saving and therefore offer generous tax breaks. There are a number of tax advantages that pensions benefit from when compared with other types of investment plans.
Understanding the way pensions benefit from tax relief and how to mitigate your tax liability using your pension pot is one way to maximise your financial position.
What is tax relief?
The tax relief you receive on your pension contributions helps you to reduce the amount of income tax you pay on your salary and other earned income.
To give you an example, if your annual salary is £50,000 and out of that you contributed £10,000 to a pension scheme, you will receive tax relief on £10,000 of your income and this means you will only pay tax on the remaining £40,000.
Using the example above, this represents an income tax saving of £2,000 (20% of £10,000). You receive this money as a credit, which is added to your pension contribution - i.e., the government top up your pension.
In the scenario above, the £10,000 annual contribution would receive an additional £2,000 in tax credit, and thus the amount actually paid into your pension would be £12,000.
This creates an amazing incentive to savers and is one of the main benefits of investing in a pension, however, you should be aware that there are limits and restrictions, which will be covered below.
How do you qualify for tax relief on your pension?
In order to benefit from tax relief on your pension, you need to make what is referred to as qualifying contributions. Tax relief is an incentive from the government for you to save for your retirement. Everyone is entitled to tax relief on pension contributions, even if they have no income.
How much tax relief can you get?
The maximum amount of tax relief you can get will depend on the amount of money you contribute to your pension. This is subject to annual and lifetime allowances and the amount of taxable income you receive.
How is tax relief calculated?
If your pension plan provides tax relief at source, you make your contribution into your pension scheme net of basic rate tax and the pension scheme provider will claim the tax relief from HMRC on your behalf and credit it to your pension plan. If you are a higher or additional rate taxpayer, you need to apply for extra tax relief through your self-assessment tax return.
The following gives an example of how this works in practice:
John wants to make a pension contribution of £10,000 to his defined contribution pension scheme. His scheme provider offers tax relief at source, so John would make a payment of £8,000 to his pension scheme provider. John's pension scheme provider would then claim £2,000, which is the amount of tax relief on basic rate income tax (20% of £10,000) from HMRC and add this money to John's contribution, topping it up to £10,000.
If john happend to be a higher rate or additional rate taxpayer, he would need to apply for extra tax relief through his self-assessment tax return.
The other benefit is that the gross pension contribution you make increases the band of income that is taxed at the basic rate – so it reduces the amount of income that is exposed to higher or additional rate income tax.
For example, if John earns £60,270 in the 2021/22 tax year, he will have to pay 40% income tax on £10,000 of his salary because this income exceeds his personal allowance of £12,570 and the basic rate tax band of £37,700 (£60,270 - £50,270 = £10,000).
If John contributed £10,000 to his pension, his basic rate tax band of £37,700 is extended to £47,700. This means his income falls within either his personal allowance or the new extended basic rate tax band and he can avoid 40% tax on the £10,000.
By doing this, John benefits from a £2,000 income tax saving, as well as the basic rate income tax relief of £2,000 he received on his pension contribution. John no longer has a higher rate tax liability of £10,000, so John effectively made a gross pension contribution of £10,000 to his pension while his outlay was in fact only £6,000.
What earnings receive tax relief?
To understand how much you can contribute to your pension and receive tax refief, you need to know how HMRC classifies your earned income. The following are examples qualifying income:
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Self-employed individual’s profits from the trading year ending in the tax year. For partners, their share of profits
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Employment income (including salary, bonuses, overtime, and commissions)
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Benefits in kind
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The taxable part of redundancy payments - the first £30,000 is tax-free
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Taxable payments in lieu of notice
Income that does not qualify includes:
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Dividends
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Savings income
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Rental income
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Pensions in payment
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State benefits
How much can you contribute to my pension?
The government has set a maximum annual limit on the amount of contributions you can make into your pension pots. This is called the Annual Allowance. This tax year (2021-2022), the Annual Allowance is limited to £40,000. If you have an annual adjusted income in excess of £240,000 or you have already accessed a pension plan using flexible income drawdown, your Annual Allowance may be lower.
You are entitled to contribute up to 100% of your qualifying earnings up to the Annual Allowance. Bear in mind, these include contributions made by your employer. If you exceed the Annual Allowance, you will no longer receive income tax relief on your personal contributions above the allowance level.
Carry forward facility
HMRC allows you to carry forward any unused allowance amount to a future tax year (maximum of three years) if you do use all of your annual allowance this year. The rules surrounding the ‘carry-forward’ facility are complex so it is best to seek advice in case you inadvertently exceed your standard annual allowance.
How much personal pension contributions can you make?
You can make personal pension contributions of up to £3,600 gross per annum, provided you are a UK resident and aged under 75. These contributions will normally benefit from basic rate income tax relief.
Your children are eligible to start a pension plan from birth and can benefit from tax relief on contributions up to this level.
If you want to contribute more than £3,600 to your pension plan then the amount you can contribute (subject to the Annual Allowance) but the amount of income tax relief you will receive will be limited by your ‘relevant earnings’.
What about your other retirement assets?
There may be other assets that can provide you with retirement income, so you should take these into consideration.
Your income in retirement could come from many sources other than a pension. This may include rental income via property, investment income, direct/company shares, inheritance, and of course, any cash reserves you have.
How much income these assets can provide you with, and to what degree this income is guaranteed should be determined in order to help you build to ensure you have adequate retirement provision.
A good starting point would be to get a clearer picture of what your retirement living costs might be and to check if your assets will generate enough income in the future to meet those living costs. You can use our cost of living calculator and retirement calculator tools to help you.
What is the Lifetime Allowance?
At present, the Lifetime Allowance in 2021/22 is £1,073,100 and it has been frozen at this amount until the 2025/26 tax year.
It had been set to increase in line with inflation, however, the Spring Budget in March 2021 saw the Chancellor freeze the limit as a way to pay back the mountain of debt incurred as a result of the pandemic.
Whilst the majority of people will stay comfortably within this limit and don’t need to be concerned, some may find that they are close to reaching this limit or in fact, have already breached it.
With the freezing of this allowance lasting for five years, even more, people may find themselves breaching the Lifetime Allowance, especially if they expect to see high investment growth within their personal pensions. This growth expectation may have been acceptable when the Lifetime Allowance was set to rise but may need to be revised now, otherwise, they may find themselves above the line.
When could you be hit with a Lifetime Allowance tax charge?
If you’re concerned that you may breach the Lifetime Allowance or you are already in a position where you are close to it, you do not have to do anything as you will not be charged until specific events take place. These events include:
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Reaching age 75 with uncrystallised funds or funds in drawdown
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Taking benefits from your pension, such as a tax-free lump sum, a regular pension amount, or placing funds into drawdown
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Passing away before age 75 with funds that you haven’t yet accessed at all (known as uncrystallised funds)
When any of these events take place, the funds being crystallised will be tested against the Lifetime Allowance, and a Lifetime Allowance tax charge could then be applied to the amount that exceeds the current Lifetime Allowance (I.e. £1,073,100 in the 2021/22 to 2025/26 tax years). For example:
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Your total pension pot = £1,400,000
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Your Lifetime Allowance (the amount before tax would be charged) = £1,073,100
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Amount on which a tax charge will be applied (as it exceeds the Lifetime allowance) = £326,900
As you have read, there are some complicated rules that need to be navigated to ensure that you don’t pay more than the rules allow (there are tax penalties if you do).
Charges of up to 55% could apply
If the funds in excess of the Lifetime Allowance are used for an income purpose such as purchasing an annuity or placing the funds in drawdown (even if no income is taken), the excess funds are subject to a 25% lifetime allowance charge (in addition to the normal income tax payable on any income payments).
If the excess funds are withdrawn as a lump sum (without going into drawdown first), the 55% lifetime allowance charge will apply (with no further income tax payable).
You could be eligible for protection
Some individuals may be eligible for ‘protection’ which essentially gives them a higher level of Lifetime Allowance, if they have been a member of a registered pension scheme since 2016. The two types of protection schemes that are still available are known as Fixed Protection 2016 and Individual Protection 2016.
You can still register for Fixed Protection 2016 if you haven’t made any pension contributions or built-up benefits in a final salary scheme (defined benefit scheme) since April 2016. If eligible, you can lock in a higher personal Lifetime Allowance of £1.25 million.
All is not lost if you have made pension contributions since 2016, as you may still be eligible for Individual Protection 2016 which protects existing pension funds valued at more than £1million on 5 April 2016. If eligible, your protection figure would be equal to the total value of your pension benefits on 5 April 2016 but capped at £1.25 million.
This would currently only give any benefit if your total benefits at 5 April 2016 were valued at more than the current lifetime allowance of £1,073,100.
What is the next step?
Pensions are complex and you need to ensure that you are armed with the correct information, based on your personal circumstances and objectives, in order to make an informed choice when choosing, or transferring, any pension plan. It is recommended that you take professional financial advice to ensure that you have the correct plan to meet your needs and that you are on track to meet your retirement goals.
Connect with an expert through our network of UK-qualified Independent Financial Advisors. Through our introduction, you will be entitled to a free, no-obligation pension review.