Pensions: Tax Considerations
Pension contributions can be a tax efficient way of accruing wealth for the future. However, consideration should be made as to the potential tax consequences that could arise as part of pension planning.
Benefits on Retirement
Most schemes will allow an individual to take 25% of their pension pot tax-free upon retirement, subject to the lifetime allowance (£1m for 2016/17). Therefore, a taxpayer could receive up to £250,000 (25% of £1m) of their pension pot tax-free upon retirement, with the remaining funds being liable to income tax. Taxpayers should discuss the most effective options for drawing these funds with a qualified independent specialist.
The government’s Pensions Advisory Service (TPAS) is available to taxpayers for free professional, independent, and impartial help with their pensions.
Employer vs Personal Pension Contributions
Workplace pension schemes are in the process of becoming mandatory under ‘Auto Enrolment’. Both employers and employees will be required to contribute a minimum percentage based on qualifying earnings into a pension.
Whilst the tax benefits of employer and personal pension contributions are similar, the method of tax relief is very different therefore it is important to understand this distinction.
Employer Pension Contributions
Employers receives tax relief for contributions to their employees’ pension. For example, a £100 contribution from the employer will increase an employee’s pension pot by £100 and the sole trade/corporate employer can offset their contribution against income tax/corporation tax on their profits.
Employer contributions are an exempt benefit and will therefore not contribute to an employee’s taxable earnings, unlike salary or other benefits. This means that neither the employer nor the employee will be subject to national insurance contributions or income tax on the value of the contribution.
Personal Pension Contributions
Individuals also receive tax relief for personal pension contributions. This relief is provided via ‘relief at source’ and (for higher/additional rate taxpayers) via the extension of tax bands.
Relief at source allows taxpayers’ pension providers to claim back the basic rate tax suffered on their contributions. For example, a personal contribution of £80 (the net contribution) is supplemented by relief at source of £20 (the tax suffered) and their pension pot is increased by £100 in total (the gross contribution).
Gross contributions qualifying for this type of relief are limited to the higher of relevant earnings and £3,600.
Higher/additional rate taxpayers can receive further tax relief through self assessment. If claimed, this relief allows taxpayer’s basic/higher rate tax bands (£32,000/£150,000 in 2016/17) to be extended by the gross contribution.
An example of the interaction between these reliefs is provided below:
Sam has a salary of £50,000 for 2016/17.
Without any personal pension contributions, Sam’s tax liability would be as follows:
£11,000 (Personal Allowance) taxed at 0% £ –
£32,000 (Basic rate tax band) taxed at 20% £ 6,400.00
£7,000 (Higher rate tax band) taxed at 40% £ 2,800.00
Total Liability £ 9,200.00
Instead, Sam choses to make a £4,000 personal pension contribution and claims relief through self assessment. Sam’s basic rate tax band would be extended by the gross contribution (£4,000 x 100/80 = £5,000) and the new liability would be as follows:
£11,000 (Personal Allowance) taxed at 0% £ –
£37,000 (Extended basic rate tax band*) taxed at 20% £ 7,400.00
£2,000 (Higher rate tax band) taxed at 40% £ 800.00
Total Liability £ 8,200.00
*Extended basic rate band calculated as £32,000 + £5,000.
If Sam were an additional rate taxpayer (income over £161,000), the additional rate band would also be extended by the gross contribution.
Basic rate taxpayers with total income below £43,000 in 2016/17 will not benefit from the tax band extensions but continue to benefit from relief at source.
Annual Allowance and the Annual Allowance Charge
Any unused annual allowance from the previous three years can be forward. The annual allowance is £40,000 for 2016/17, 2015/16, and 2014/15, and was £50,000 for 2013/14.
Where total contributions (including employer and personal contributions) exceeds the annual allowance (plus any carried forward), tax relief will be withdrawn via the annual allowance charge, which subjects excess contributions to the taxpayer’s marginal rate of tax.
The annual allowance is also reduced by £1 for every £2 of income above £150,000, subject to a minimum allowance of £10,000.
Subject to certain criteria, it is possible for a taxpayer to bequeath their pension to their beneficiaries upon death, without any tax restrictions on the beneficiaries.
‘Defined contributions’ or ‘defined benefits’ will not normally be taxable provided:
- the pension owner was under 75 when they died,
- the beneficiary is paid within 2 years of the death, and
- the pension is in the form of a lump sum or new annuity/money from a drawdown fund (‘new’ meaning set up and first accessed from 6 April 2015).
Tax may be applicable in other cases and will depend on a number of factors including the type of pension/payment, age of owner, and the size of the pension pot.
Please contact us you have any queries regarding the tax consequences of pensions.