Tax and Allowances
When you are deciding how you want to use your pension savings, it is important to consider the tax you would pay on the different options, and also the benefits you will receive from the State.
How does tax on pension savings work?
When you are building up savings…
You won’t usually have to pay tax as you save into a pension unless the amount you save, or build up, over the tax year exceeds the Annual Allowance.
This means that saving into a pension arrangement is usually tax efficient, as you receive tax relief at your highest marginal rate of income tax.
For example, if you are a basic rate tax payer, for every £100 you save into a pension, this only costs you £80.
When you retire
When you retire – that is – you access your pension savings – the value of your pension savings will be tested against the Lifetime Allowance.
If your pension savings are greater than the Lifetime Allowance, then you will need to pay an additional tax charge; your pension savings can be reduced to meet this charge or you can meet this charge yourself.
In most cases, you can usually take up to 25% of the value of your pension savings within the Lifetime Allowance as a tax-free cash lump sum.
Alternatively, if you are moving into a drawdown fund or taking more than one cash lump sum, then you may be able to spread your tax-free cash over a number of years by taking 25% of each future payment tax-free.
When you’re drawing a retirement income
Once you have taken any tax-free cash at retirement, and paid any additional tax charges if you exceed the Lifetime Allowance, the remainder of your retirement income will be taxed at your marginal rate of income tax as you receive it.
This works in a similar way to the tax you currently pay on your employment income, except you won’t have to pay any National Insurance Contributions.
If you have transferred your benefits and are spreading your tax-free cash by taking 25% of each payment tax-free, then any amount above this on each payment will be taxed at your marginal rate of income tax.
What are the Allowances?
The three Allowances which apply to pension savings are the Annual Allowance, the Lifetime Allowance and the Money Purchase Annual Allowance.
Annual Allowance
The Annual Allowance (AA) is the maximum value of pension savings you can build up over a tax year without incurring a tax charge. The Government review and can change this allowance on an annual basis. For the latest information and Annual Allowance figures, please visit this Government website
Lifetime Allowance
The Lifetime Allowance (LTA) is the maximum value of pension savings you can build up over your lifetime (in all arrangements) without incurring an additional tax charge. The Government review and can change this allowance on an annual basis. For the latest information and Lifetime Allowance figures, please visit this Government website
You may have a higher LTA than shown on the above website if you applied for a form of LTA protection when the LTA reduced in previous years. It is your responsibility to let the administrators of your pension arrangements know if this applies to you.
Each time you start to use your pension savings, you will be told how much of your LTA you have used. It is up to you to tell each pension arrangement that you are taking savings from how much of your LTA you have used. If you don’t have enough LTA left to cover the value of the pension savings you are using you’ll need to pay the additional tax.
If you expect to exceed the LTA and you have pension savings in both a final salary and a defined contribution pension, you should consider the order in which you access your pension savings as this can impact on the LTA value and how much additional tax you must pay.
If you are affected by the Lifetime Allowance, you should discuss the implications with your financial adviser.
Money Purchase Annual Allowance
The Money Purchase Annual Allowance (MPAA) applies once you have accessed your pension savings ‘flexibly’ and taken a taxable income. This includes taking taxable income from a drawdown account, as well as the taxable part of a cash lump sum. It doesn’t apply if you buy an annuity or if you take a small pot lump sum.
Once the MPAA is triggered, this restricts the amount of pension savings you (and your employer) can make into a money purchase (defined contribution) pension arrangement each tax year without incurring a tax charge. For the latest information and MPAA figures, please visit this Government website
You will need to make sure that you tell any other defined contribution pension arrangements that you are continuing to save and that you are subject to the MPAA so that they can assess your contributions against this lower level.
To assist you with this notification, your pension provider should send you a ‘flexible-access statement’ within 31 days of you first taking a taxable withdrawal. You will then need to let your other pension providers know within 13 weeks of receiving your ‘flexible-access statement’, otherwise you may be subject to a fine.
Therefore, if you are planning to continue working and/or saving into a pension arrangement after taking any of your pension savings, you should take the MPAA into account when deciding which option to take and discuss this with your financial adviser.
What tax will my dependants pay on my death?
The amount of tax your dependants pay depends on how you take your pension savings and how old you are when you pass away. If you take the Plan pension, your dependant will pay tax on their pension in a similar way to the way your pension was taxed (see above).
| If you die… | Annuity | Drawdown | Cash |
|---|---|---|---|
| If you die…Before age 75 | AnnuityIf you have bought a joint-life annuity, which includes a regular income for your dependant following your death, they will receive their income tax-free for the rest of their life. | DrawdownYour dependants may receive a tax-free lump sum or receive a tax-free income – if the payments start within two years of your death. | CashAny cash remaining from your pension savings that you have taken as a cash lump sum will form part of your estate for inheritance purposes. |
| If you die…Age 75 or over | AnnuityIf you have bought a joint-life annuity, which includes a regular income for your dependant following your death, they will receive their income for the rest of their life and will be taxed at their marginal rate of income tax. | DrawdownYour dependants will pay tax at their marginal rate of income tax, whether the account is paid as a lump sum or a regular income. | CashAny cash remaining from your pension savings you have taken as a cash lump sum will form part of your estate for inheritance purposes. |
Note that additional tax charges may apply if you die before age 75 and you do not have sufficient unused Lifetime Allowance (LTA) to cover any pension savings you have not yet accessed.
Tax on your State Pension
Income from your State Pension will be taxed at your marginal rate of income tax, in the same way as other retirement income.