There are ample tax benefits to take advantage of when you’re saving into a personal pension, and the good news is that the tax breaks don’t end once you’re in retirement. Thanks to government-led incentives, there are some simple ways you can make your money go even further, to give you the retirement income you deserve.
Once you get to the age of 55, you can take 25% of your pensions savings as a tax-free lump sum. You decide what you want to do with it, whether that’s invest it, spend it on home improvements, help your children on the property ladder, or swap it for an annuity.
Be careful though, if you’re in a defined contribution scheme, once this money has been spent, it’s gone for good.
Taking this lump sum doesn’t get included when your taxable income is calculated. This means you can still withdraw an additional £11,850 in the 2018/19 tax year, for example, before you qualify to start paying income tax.
Your total income could include your state pension, an additional state pension, private pension, earnings from employment or self-employment taxable benefits and any other income from investments, property or savings. You may get more than one tax code, so it’s important you check this to ensure you’re being charged correctly.
You’ll pay your normal rate of income tax on the rest of your earnings above the £11,850 threshold. If you fall in the basic rate tax band you’ll pay 20%, 40% if you fall in the higher rate band, and 45% if you’re in the additional tax band.
Although you may still be required to pay income tax on your pension income, the charge might be less than the relief you received on your pension contributions during your employment. By the time you’re in retirement, your total income will likely be lower than when you were employed, potentially moving you into a lower tax band.
By the time you get to state pension age, you’ll no longer be required to pay National Insurance contributions.
Should you take your tax-free lump sum?
Thanks to pension freedoms, you can keep your pension savings invested throughout retirement instead of being forced to swap your pot for an annuity. Whilst annuities play a reliable part in financial planning for retirement, it’s important people have the opportunity and flexibility to make the best decisions with their money to suit their lifestyle and financial background.
Although an annuity offers a regular income throughout your retirement, by keeping your money invested in the stock market, you hope to grow your pension pot over the long-term.
It might seem that you have to take 25% tax-free when you get to the age of 55, but you don’t. Instead of taking your lump sum, you can get 25% of each withdrawal tax-free instead, and pay income tax on the rest.
As you won’t have taken your tax-free lump sum, this is known as a uncrystallised funds pension lump sum (UFPLS).
If you withdrew £10,000, £2,500 would be tax free. The remainder would be taxed at your marginal rate of income tax. You’ll need to tell HMRC about your new tax code as you may find you get placed on emergency tax.
It’s reasonable to assume your investments will grow by an annualised 5% over the long-term, according to research from the FCA. That means you could get more money tax-free by refusing to take the 25% lump sum at the offset and giving your money the opportunity to grow.
Keeping your money invested for longer can also be good in terms of inheritance tax. No inheritance tax is charged on pensions if you die before the age of 75. If you withdraw your tax-free lump sum, this may be counted as part of your estate, which could increase the inheritance tax bill your loved ones have to pay.
Tax relief when saving on your pension contributions
When you’re putting money into your pension for the future, you can claim generous tax relief from the government which can help boost your savings and, ultimately, help you retire quicker or with a better income.
This tax relief is calculated relative to your income tax band. If you fall in the basic rate tax band, you’ll get 20% relief on your pension contribution. This turns a £10,000 deposit into £12,500 and is automatically added to your pension contribution at source.
If you pay the higher rate of tax or additional, you can claim back more through your self assessment tax form. Although you won’t get the money in your pension, it’s usually reflected in your tax code. You can add this back into your pension to make your money go even further.
In Scotland, the rates differ slightly, with an additional 19% and 21% tax band, and the higher and top rate rising by 1% to 41% and 46%. Those on starter rates of 19% still get 20% tax relief.
Money Purchase Allowance
Once you start withdrawing from your pension, you might be subject to the Money Purchase Annual Allowance. This restricts the amount you can contribute to your pension to £4,000 a year before a tax charge is payable.
Whilst taking your 25% tax-free lump-sum won’t trigger your Money Purchase Annual Allowance, there are a number of ‘trigger events’, also known as ‘accessing flexibility’. You may enter the MPAA in one of the following situations, although if you’re unsure please speak to a financial adviser.
- Taking an uncrystallised fund pension lump sum
- Entering flexi-access drawdown income
- Going above capped drawdown income threshold
- Through existing flexible drawdown
- Withdrawing stand-alone lump sums
- Taking a flexible annuity
- If your pension scheme has less than 12 members
Make the most of your ISA allowance
Whilst the amount you can contribute to your pension will fall once you start withdrawing regularly from your pension, you’ll still be able to make the most of your ISA allowance.
You can invest up to £20,000 each year, and any growth in the value of your investments and any income will be able to grow tax-free for as long as it’s protected in your tax-free wrapper.
As it’s an individual wrapper, both you and a partner can invest up to £40,000 a year. ISAs are more flexible than pensions, and you can put money in and withdraw from your ISA throughout the tax year.
Both pensions and ISAs are simple investment wrappers, but they are both crucial when planning your financial future and can make all the difference in the long run.
If you are unsure of your tax situation, please seek independent financial advice.