Understanding how your pension is taxed

There’s no ques­tion about it, pen­sions are offi­cial­ly the most tax-effi­cient way you can store your mon­ey in the UK. A whole range of incen­tives have been devel­oped over the years to encour­age work­ers to save for retire­ment and for their employ­ers to assist them. 

How­ev­er, they can also be quite com­pli­cat­ed. Accord­ing to Jon Dean, head of retire­ment strat­e­gy at finan­cial con­sul­tan­cy Altus, explain­ing tax­a­tion remains “one of the biggest chal­lenges for pen­sion firms when encour­ag­ing peo­ple to save for the long term”. Yet under­stand­ing them will help ensure your pen­sion pot goes as far as it can.

Adding to the com­plex­i­ty, these ben­e­fits may shift slight­ly when­ev­er a new gov­ern­ment pol­i­cy is announced. Cur­rent­ly, there is spec­u­la­tion over what might be unveiled in chan­cel­lor Rishi Sunak’s March 2021 Bud­get.  

With the coro­n­avirus pan­dem­ic and relat­ed reces­sion push­ing pub­lic bor­row­ing to record lev­els, it’s like­ly the gov­ern­ment will be look­ing to make sav­ings wher­ev­er it can. So how might we see the way pen­sions are taxed change and what can we do to best pre­pare?

Generous tax relief

One of the most impor­tant pen­sion tax ben­e­fits to under­stand is the tax relief offered on con­tri­bu­tions up to £40,000 a year. For every £80 a basic-rate tax­pay­er in the UK, exclud­ing Scot­land, pays into their pen­sion, the gov­ern­ment tops it up to £100. This reduces to £60 for high­er-rate tax­pay­ers and £55 for addi­tion­al-rate tax­pay­ers. 

“Less well under­stood is the fact you can still save up to £3,600 a year into a pen­sion, or for chil­dren if you’re not work­ing, and still ben­e­fit from the government’s 20 per cent uplift,” advis­es Dean. So in effect, this would only cost you £2,880.

There have been calls over the years for tax relief on high­er earn­ers to be reduced. Accord­ing to Dean, addi­tion­al-rate tax­pay­ers make up only 11.7 per cent of the work­force yet rep­re­sent half of all tax relief. There have even been sug­ges­tions that a sin­gle flat rate of tax relief should be intro­duced. 

Dean describes this as “a polit­i­cal hot pota­to” that would par­tic­u­lar­ly impact those with pub­lic sec­tor pen­sions, which are tied to salaries, the very same peo­ple who have been shoul­der­ing soci­ety dur­ing the pan­dem­ic. 

Neil Jones, tax and wealth spe­cial­ist at Cana­da Life, says gov­ern­ments keen to make sav­ings are more like­ly to low­er the total size of the pot that can be kept tax free, rather than inter­fere with tax relief. This is the total amount you can have stashed away with­out any of the inter­est on it being taxed. It cur­rent­ly stands at £1,073,100, but has been high­er in the past.

Withdrawing an income

Anoth­er major aspect of pen­sion tax­a­tion is the tax-free lump sum. When you first dip into your pen­sion pot, you can take 25 per cent out and use it as tax-free income. Pre­vi­ous­ly, this was released when you took out an annu­ity – a type of insur­ance con­tract that gave you an income from your pen­sion for life – until then-chan­cel­lor George Osborne intro­duced what’s known as “pen­sion free­doms” in 2015. 

These allow all savers to dip into their pen­sions from the age of 55 onwards and were designed to reflect the chang­ing nature of retire­ment. The lump sum can, for exam­ple, sup­ple­ment part-time work or be used to plug the gap between ear­ly retire­ment and the state pen­sion kick­ing in. 

How­ev­er, the cur­rent eco­nom­ic cli­mate may have forced some of us to dip into this just to make ends meet. HM Rev­enue & Cus­toms fig­ures for the fourth quar­ter of 2020 show there was a 10 per cent increase in flex­i­ble with­drawals from pen­sions com­pared to the same peri­od in 2019. 

Tom Sel­by, senior ana­lyst at invest­ment plat­form AJ Bell, warns that any­one wish­ing to use their pen­sion in this way needs to be aware of the tax impli­ca­tions as once you with­draw more than 25 per cent, the amount of con­tri­bu­tions you can enjoy tax relief on drops from £40,000 a year down to just £4,000. This means that top­ping your pot back up becomes increas­ing­ly dif­fi­cult. “We are push­ing the gov­ern­ment to look at whether some­thing can be done to make this fair­er,” he says. 

Dean adds that cap­ping the tax-free lump sum could be an alter­na­tive mon­ey-saver for the gov­ern­ment; a sim­i­lar cap was recent­ly intro­duced in Ire­land. “How­ev­er, the lump sum is the best under­stood part of UK pen­sion rules,” he adds. “So this would just be adding fur­ther com­plex­i­ty.”

Passing your pension on

For those in the oppo­site sit­u­a­tion, with a pen­sion pot so large they won’t get through it all before they die, there are also ben­e­fits as the pot can be passed down to ben­e­fi­cia­ries free of inher­i­tance tax if death is before the age of 75. This means that, for those with enough assets, it’s bet­ter to work through ISAs and mon­ey gained from prop­er­ty before with­draw­ing your pen­sion. Most experts don’t see this chang­ing for the time being, but it would cer­tain­ly be less polit­i­cal­ly risky than chop­ping oth­er tax ben­e­fits. 

One rumour cur­rent­ly doing the rounds is that the Bud­get could include changes to cap­i­tal gains tax, with the per­cent­age paid poten­tial­ly being tied to an indi­vid­u­al’s exist­ing tax brack­et. If this does mate­ri­alise, Sel­by says it would cre­ate an even big­ger incen­tive to invest as close to your annu­al £40,000 allowance in your pen­sion as pos­si­ble. “Mov­ing your mon­ey into a self-invest­ed per­son­al pen­sion and ISAs could become a bet­ter move than prop­er­ty invest­ments,” he adds.

Over­all, experts advise edu­cat­ing your­self on the ben­e­fits avail­able and keep­ing track of any changes that may affect you remains the best way to pre­pare for a com­fort­able retire­ment. “The start­ing place for most peo­ple is always their work­place pen­sion,” says Sel­by. If you can afford more than your £40,000 annu­al allowance, then seek inde­pen­dent finan­cial advice on where the best place for your mon­ey is. “Try­ing to guess a chancellor’s next moves is always a tricky game,” Sel­by con­cludes.