Pensions rules explained
Find out everything you need to know with our Q&A guide.
Q) How does tax relief on pension contributions work?
A) To encourage people to save for their retirement, the government will pay tax relief on money you pay into a pension. This is equivalent to the level of income tax you pay and effectively means you make your contributions from pre-taxed income.
So, if a basic-rate taxpayer pays in £80, the government will top-up that contribution to £100 thanks to tax relief at 20%. A higher rate taxpayer gets tax relief at 40% so would only have to pay £60 to invest £100, while an additional rate taxpayer with tax relief at 45% would pay just £55. The tax relief offered on pension contributions is under review by the governement however and experts predict the current tiered system may be replaced with a flat rate.
If you are a member of a workplace scheme your employer will deduct your pension contributions from your salary before tax has been paid, meaning you only pay tax on the remainder. This means you get the full benefit of tax relief at whatever rate of income tax you pay and need to take no further action.
The situation is different for personal pensions as your contributions will be paid from your own taxed income. As a result your pension provider will claim 20% tax relief back from the taxman on your behalf. Higher rate taxpayers can claim a further 20% back, either through their tax return or by writing to or phoning HMRC. Additional rate taxpayers can claim a further 25% but this does need to be done through a tax return.
Q) Are there any other tax benefits to saving in a pension?
A) Yes. On top of tax relief on contributions, money saved in a pension will largely accrue tax-free (as with Isas, 10% tax is payable on UK dividend income). When you retire you can take up to 25% of your fund as a tax-free cash lump sum to spend or invest as you choose.
You will have to pay income tax on the income the remainder generates, unless of course it does not exceed your personal allowance. In 2015/16 the personal allowance for somebody born before 6 April 1938 is £10,600 or £10,660 for those born between 6 April 1938 and 6 April 1948.
When you die any money in a pension will be paid to your chosen beneficiaries free of inheritance tax. It will also be passed on free of income tax if you die before age 75.
Q) How much can I pay into a pension?
A) Each year you can contribute an amount equal to 100% of your earnings into as many pensions as you like and still get tax relief. However this is subject to an annual allowance which has, somewhat controversially, been slashed in recent years.
In April 2011 the amount you can pay into a pension was reduced from £255,000 a year to £50,000 and at the start of the 2014/15 tax year it fell again to £40,000.
If you pay in more than the annual allowance you will be liable for a tax charge on the excess. However, the good news is that you can carry forward any unused allowance from the last three tax years to the current tax year, meaning you may be able to avoid the charge.
Non-taxpayers can pay into a pension and still benefit from tax relief at the basic rate (20%). You can pay in a maximum of £2,880 which then gets topped up to £3,600. You can also set up a scheme for a non-taxpayer and pay into it on their behalf (this might be a spouse or civil partner or a child or grandchild) and get tax relief at this rate.
In addition to the annual allowance, which governs how much you can pay in each year, there is also a lifetime allowance. If the total value of your pensions exceeds this limit a tax charge will apply.
Again this allowance has been reducing over the years. In 2011 it stood at £1.8 million but fell to £1.5 million at the start of the 2012 tax year before falling again to £1.25 million at the start of the 2014 tax year. In April 2016 the axe will fall again bringing it down to a round £1 million.
Savers who are concerned that their funds already exceed the £1.25 million cap can apply for protection for up to £1.5 million.
Although the reductions have been made to target the wealthiest of individuals, experts have expressed concern that its not just extreme earners that will be caught out. Long serving members of final salary schemes could be particularly vulnerable, even if they are only on a middle income.
Furthermore, figures from MGM show that a pension worth £1.25 million might not generate as high an income as many would expect. After taking his 25% tax-free cash (£312,500) a healthy 65-year-old male with a pot this size would get an index-linked income of £26,850 a year (with 50% spouse protection).
Q) What happens to my pensions when I retire?
A) You can access your pensions any time from the age of 55. Traditionally pensions have been regarded as very inflexible savings vehicles, with strict rules governing what you do with the money you saved, however this all changed in April 2015.
A relaxation of pension rules now mean savers can spend their pension as they wish.
If you want the certainty of a fixed income you will still be able to purchase an annuity, or if you are happy to accept the risk of leaving your money invested you can enter into an income drawdown agreement. Here you keep your money in your pension but start taking an income from it. Alternatively you can cash in your pension and spend – or invest – the money as you choose.
Prior to these changes savers were essentially forced into buying poor value annuities that might only pay out a few pounds a week.
Up to 25% of any pension you cash in can be taken as a tax-free lump sum, however the remainder will be worked into your income for that year and you will be taxed at your marginal rate. So you will need to be mindful that by cashing in your pension you may put yourself into a higher tax bracket.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.