Understanding pension taxes
Navigating the complexities of pensions can be daunting, especially when tax implications come into play. However, a basic understanding can help you make informed decisions and maximise the benefits of your pension scheme. This post aims to provide a comprehensive overview of how pension tax works in the United Kingdom.
The Basics of Pension Schemes
In the UK, there are mainly two types of pension schemes:
Defined Contribution
Contributions from both you and your employer are invested, and the returns are used to buy a pension or other benefits at retirement.
Defined Benefit
Your pension is based on your salary and how long you’ve been a part of the scheme, rather than investment returns.
Tax Relief on Contributions
One of the main advantages of pension contributions is tax relief. The UK government provides tax relief at your marginal rate, meaning:
Basic-rate taxpayers get 20% tax relief
Higher-rate taxpayers get 40%
Additional-rate taxpayers get 45%
Tax relief is provided in different ways, depending on your pension scheme:
Relief at Source
You contribute from your net income, and your pension provider claims tax relief at 20% from HMRC. Higher and additional-rate taxpayers will need to claim the extra relief through their Self-Assessment tax return.
Net Pay Arrangement
Contributions are taken from your gross income before tax is calculated, automatically giving you tax relief at your marginal rate.
The Annual Allowance
There is an annual limit to how much you can contribute to your pension and still receive tax relief. The current annual allowance is £60,000. If you exceed this limit, you'll have to pay a tax charge known as the Annual Allowance Charge.
The Lifetime Allowance
The lifetime allowance is the total amount you can save in your pension pot without triggering extra tax charges. At the time of writing, the lifetime allowance is £1,073,100. Exceeding this will result in a tax charge on the excess amount when you take money out of your pension pot or reach age 75.
Withdrawing Your Pension
You can usually start withdrawing from your pension pot from the age of 55 (this age will rise to 57 in 2028). Here are the tax implications:
Tax-Free Lump Sum
The first 25% of your pension pot is usually tax-free. The remaining 75% is subject to income tax.
Flexible Drawdown
If you opt for flexible drawdown, any withdrawals beyond the 25% tax-free lump sum are taxed as income at your marginal rate.
Annuities and Income Drawdown
If you purchase an annuity or opt for income drawdown, the income you receive will be subject to income tax at your marginal rate, just like any other income.
Inheritance Tax
If you die before age 75, your pension can usually be passed on tax-free. After 75, the person inheriting your pension pot will have to pay income tax at their marginal rate.
Conclusion
Understanding pension tax in the UK is crucial for making smart choices for your retirement. With favourable tax relief and various options for drawing your pension, making informed decisions now can secure your financial future. Consult a financial advisor for personalised guidance tailored to your specific circumstances.
Approved by In Partnership FRN 192638 November 2023