Tax on Private Pensions (AKA, Defined Contribution or Money Purchase pensions)
We love pensions and we believe you should too! After all, its not often you get some free money from the Government! Basically, when you put money into a recognised pension scheme, HMRC will provide “tax relief” meaning they will put some money in too – giving your savings a boost immediately! For example, lets say you put £100 into a pension, HMRC will add a further £25 meaning you have £125 in your pension straight away! If your lucky enough to be a higher rate taxpayer, you can then even reclaim a further £25 via self-assessment meaning it only cost you £75 but have £125 in your pension – wow! Why would the Government basically give everyone some free money? Well they want people to save for their retirements to ultimately reduce dependence on state benefits for example. Given pensions are very generous, there are strict limits on how much you can pay into them. Those limits being subject to:
Annual Allowance – This is the maximum you can save into your pension in a given tax year. Currently this is £40,000 per annum. You will pay the tax relief back if you go over this amount.
This allowance may be reduced if you take money out of your pensions and depending on how you take it. Care is needed as in some circumstances you can trigger something called the Money Purchase Annual Allowance (MPAA), resulting in a permanently lower annual allowance of £10,000 per year.
Read more on the MPAA here – https://financialfortress.co.uk/money-purchase-annual-allowance/
Lifetime Allowance – This is the maximum amount you can save into pensions during your lifetime. If your total pensions are worth more than the allowance (currently £1,073,100 in tax year 2023/24) there will be a tax charge of either 25% or 55% depending on how you withdraw the excess!
Tax-free Growth – Don’t forget, your pension will also grow tax-free along the way meaning your money should grow faster as the tax-man is not “taking a cut” along the way!
Here is a link to the UK Governments latest advice on claiming tax relief:
Health warning: Taxation is different to each and every person reading this so it is very important you get personalised advice!
The two types of payment from a pension fund are:
Tax free lump sum / Pension commencement lump sum
Final Salary pension scheme – provided by a calculation which the scheme itself completes. We call this calculation “commutation”.
A personal or individual pension – Usually 25% of the fund value at the point of “crystallisation”. Crystallisation means when you draw it out. Be aware however, some older schemes may have “protected tax-free cash” which will allow you more than the standard 25% to be drawn tax-free. The “enhanced” or “protected” tax free cash could be anything above 25%, including even 100% in very rare cases!
As the name suggests, these payments of tax-free cash (within the Lifetime Allowance) are paid tax-free
Taxable income / scheme income / annuity income / drawdown income
All UK pension schemes, whether occupational (from group / workplace arrangements) or personal (from individual arrangements) will pay taxable pension income via the PAYE (pay as you earn) system. Basically, they will try to deduct the correct amount of tax before payment is made to the member (you) and pay this across to HMRC on your behalf. This avoids complicated paperwork such as self-assessment and should help avoid big tax bills.
HMRC will provide the payroll operator (ie: the pension company) with a “tax code” based on the members individual circumstances. (All in a very similar way to how an employer would pay your wages).
When could I pay more tax? (Emergency tax codes)
When you receive your first income payment from your pension provider, they will then notify HMRC that you should now be included in their payroll records. HMRC should then send the correct tax code for the payroll operator to use. As this can take a little time (usually 2 or 3 months), pension income providers will use what is known as “Emergency month 1 basis” until this is received. Result – you will probably pay too much tax!
This means, the pension company will test each individual payment against one-twelth (1/12) of the personal allowance. This will usually result in an overpayment of tax. When the “tax coding” catches up, this should subsequently be corrected, however to speed this up you can complete a “P55 form”.
Other points to consider
- Scotland and Wales now have additional rates of tax payable but during the time where no tax code has been received, the English rates will be used initially.
Summary of Taxation
- Get Tax Relief (ie: extra money on your contributions
- Any growth is also tax free
- At retirement, Take your 25% tax free cash
- Reduce tax on income using your personal allowance,
- At retirement, the remaining funds (after tax-free cash) are drawn subject to tax,
Pension Tax Frequenty Asked Questions (FAQ’s)
Do I have to pay tax on my pension?
When your funds are growing it is the reverse, you actually get tax back (ie: the free money) on your contribution! When you actually retire, withdrawals in excess of your available tax-free cash will be taxed as income at your marginal rates, You will not however pay national insurance on pension income!
How does tax relief work?
HMRC tops up your pension by the basic rate of tax (ie: 20% in tax year 2023/24) giving your savings a boost. If you are a higher rate taxpayer (income more than £50,270 for the tax year 2023/24) then you can claim back a further 20% via self-assessment.
Can I avoid paying tax on my pension?
Where you have no other source of taxable income (for example through work or a pension in payment), you can withdraw up to £12,570 (2023/24 limit) per tax year (6th April to 5th April every year) and avoid paying any tax what-so-ever! If you have any taxable income but less than £12,570 then you can “top up” your tax free income with your pensions!
What percentage of my pensions are tax-free?
You will be able to draw atleast 25% of your pension pot completely tax-free once you become eligible. Sometimes pensions offer “protected tax-free cash” meaning you may be entitlked to more than the standard 25% so it is very important you check with your scheme first! You can then draw the “tax-free cash” as either a lump sum or regularly as a further source of income if preferred. Let us assume you have no other income, you could in theory draw a maximum of £16,760 per year and pay no tax!
How do I calculate tax on my pension?
This is completed at scheme level through the PAYS (Pay as you earn) system. With all income, the tax-free cash element is free of tax and the remaining 75% is taxed at marginal rates. Expert advice is usually needed and care should be exercised to avoid any large tax bills!
Ready to build your Financial Fortress?
Speak to one of our specialist pension advisers today! We will go through your options in more detail and help you build a tailored plan based on your circumstances to ensure a successful retirement!
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