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 total amount saved into the HRP 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.
Plan contributions are usually paid through salary sacrifice, which means they are paid before tax. You can read more in your Plan booklet.
When you retire
At retirement you can generally take up to 25% of your pension pot as a tax-free lump sum (no income of capital gains tax). However, this cash free lump sum is limited.
The size of any tax-free sum will depend on how you take your pension(s) and may be paid in several tranches but the total limit, across all your arrangements, is currently £268,275. This equates to 25% of the old Lifetime Allowance (LTA).
Historically, funds drawn from your pension in excess of the LTA were subject to an LTA charge of 55% whereas, the lump sum allowance now means they are treated as income so taxed at your marginal rate of income tax).
When you’re drawing a retirement income
Once you have taken any tax-free cash at retirement, 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 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?
Annual Allowance
The three Allowances which apply to pension savings are the Annual Allowance, the Lifetime Allowance and the Money Purchase 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 reviews, and can change this allowance on an annual basis. For the latest information and Annual Allowance figures, please visit this Government website
Lump Sum Allowance
Under certain circumstances, either:
- you can also receive a serious ill-health lump sum; or
- your beneficiaries can receive a lump sum death benefit
Both are tax-free up to a maximum of £1,073,100. This is your lump sum and death benefit allowance.
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, known as an Uncrystallised Funds Pension Lump Sum or UFPLS. 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 into 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.
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 die… | Annuity | Drawdown | Cash |
|---|---|---|---|
| If you die…Before age 75 | AnnuityIf you have bought a joint 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 annuity, which includes a regular income for your dependants 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 cash lump sum will form part of your estate for inheritance purposes. |