In today's tutorial we are going to take a closer look at the Tax implications of Private Pensions*.
The general principle is that when you are building your Private Pension through contributions, these are tax free up to certain limits. However you will pay tax when you take money out of your pension (e.g. you have retired and started drawing an income).
This applies to the following categories of private pension: workplace pensions, personal & stakeholder pensions and overseas pension schemes that qualify for UK tax relief (a "qualifying overseas pension scheme"; confirm with your provider).
There are limits to tax free pensions contributions:
you can only get tax relief on private pension contributions of up to 100% of your annual earnings
you don't exceed your Annual Allowance (currently £40,000 per annum)
you don't exceed your "Lifetime Allowance" (currently £1,030,000)
But your Pension Provider must be registered with Her Majesty's Revenue and Customs (HMRC) & they need to invest your pension pot according to HMRC rules.
You get tax relief automatically if:
your employer takes workplace pension contributions out of your pay before deducting Income Tax
pension provider claims tax relief for you at a rate of 20% and adds it to your pension pot (‘relief at source’)
You get relief at source in all personal and stakeholder pensions, and some workplace pensions.
For Higher Rate & Additional Rate tax payers, further tax relief of 20% (Higher Rate) and 25% (Additional Rate) needs to be re-claimed trough the Annual Self Assessment return.
This is a limit to the total amount of contributions or benefits that are built up in pension schemes each year, for pensions tax relief purposes. The annual allowance is currently capped at £40,000**, but you can carry-over any unused allowances from the previous three tax years.
Reduced Annual allowance for high incomes if both the following conditions apply
your income excluding any pension contributions (your "threshold income") is over £110,000 and
your "adjusted income" is over £150,000 (your income added to any pension contributions you or your employer make) ***
your annual allowance will be reduced as follows:
For every £2 your adjusted income goes over £150,000, your annual allowance for that year drops by £1. The drop is limited so that the minimum tapered annual allowance you can have is £10,000.
How to work out if your contributions are within the annual allowance limit
The approach is different for the two main types of pension:
defined contribution: these pension schemes invest the contributions made by you and/or your employer, in a range of different investments. You may be offered a choice about how your contributions are invested.
The benefits that you receive at retirement depend on:
how much has been paid in on your behalf (by you and/ or your employer);
the length of time that it has been invested; and
how the investments have performed over this period.
defined benefit (final salary or career average): these pension schemes provide retirement benefits based on your earnings and the length of time that you have been a member of the scheme
Use this tool to identify which type of pension you hold.
Annual Value of Defined Contribution Pension: you add all of the contributions that you and your employer pay into your pension in the relevant year ****
Annual Value of Defined Benefit Pension: the increase in the value of your retirement benefits each year is used to calculate how much of your annual allowance the scheme uses.
The calculation can be complex and you can always ask your pension scheme administrator for advice & help.
You will have to establish "Opening Value" & "Closing value"; the difference between these is the increase of your retirement benefits (two worked examples are included below).
Opening Value: total amount of annual pension built up immediately prior to the start of the year/pension input period (e.g. start of tax year), multiplied by 16. You need to add any lump-sum entitlement built up in the pension plan as of the same valuation date & apply CPI inflation figure to the combined total. CPI Inflation figure to be used is the number for September prior to your valuation date.
Closing Value: total amount of annual pension built up by the end of the year/pension input period (e.g. end of tax year), multiplied by 16.
Following are two examples from the Pension Advisory Service website:
Example 1: 1/60th accrual rate, no separate lump sum entitlement
Tina is a member of a final salary scheme giving her a pension of 1/60th pensionable pay for each year of service. At the start of the pension input period Tina’s pensionable pay is £80,000 and she has 31 years pensionable service. At the end of the pension input period Tina’s pensionable pay has risen by 5 per cent to £84,000 with 32 years pensionable service.
Tina does not have any other pension arrangement.
Tina’s total pension input amount is the increase in the value of her pension saving over the year. This is the difference between the opening value and the closing value of her promised benefits.
Tina’s opening value is calculated as:
find amount of annual pension: 31/60 x £80,000 = £41,333.33
multiply annual rate of pension by flat factor of 16: £41,333.33 x 16 = £661,333.28
increase by CPI (for the purpose of this example, 3 per cent); £661,333.28 x 1.03 = £681,173.27. This represents Tina’s opening value.
Tina’s closing value is calculated as:
find amount of annual pension: 32/60 x £84,000 = £44,800
multiply annual rate of pension by flat factor of 16: £44,800 x 16 = £716,800. This represents Tina’s closing value.
The difference between the closing value and the opening value is £35,626.73 and this is Tina's pension input amount. As this is below the £40,000 annual allowance, no further tax is payable.
Example 2: 1/80th pension + 3/80th lump sum
Asif belongs to a pension scheme that gives him benefits of:
a pension of 1/80th final salary for each year of pensionable service a separate lump sum (i.e. not by commutation of pension) of three times his pension At the start of his pension input period Asif’s pay is £60,000 and he has been a member of the scheme for 14 years. At the end of his pension input period Asif’s ‘final pay’ has increased by 5 per cent to £63,000 and he has 15 years scheme membership.
Asif does not have any other pension arrangement.
At the start of Asif’s pension input period the value of his benefits (the opening value) is calculated as:
find amount of annual pension: 14/80 x £60,000 = £10,500
multiply annual rate of pension by flat factor of 16: £10,500 x 16 = £168,000
add amount of separate lump sum £168,000 + (3 x £10,500) = £199,500
increase by CPI (for the purpose of this example, 3 per cent): £199,500 x 1.03 = £205,485. This represents Asif’s opening value.
At the end of Asif’s pension input period the value of his benefits (the closing value) is calculated as:
find amount of annual pension: 15/80 x £63,000 = £11,812.50
multiply annual rate of pension by flat factor of 16: £11,812.50 x 16 = £189,000
add amount of separate lump sum: £189,000+ (3 x £11,812.50) = £224,437.50 This represents Asif’s closing value.
The increase in Asif’s benefits over the pension input period is £18,952.50 and this is Asif’s pension input amount as he does not have any other arrangements to take into account for the same year.
Again, as this is below the £40,000 annual allowance, no further tax is payable.
Exceeding the annual allowance:
If you have exceed the annual allowance (including any carry-over from previous tax years), you won't receive tax relief on any contributions paid that exceed the limit and you will be faced with an annual allowance charge. The annual allowance charge will be added to the rest of your taxable income for the tax year in question, when determining your tax liability.
Alternatively, if the annual allowance charge is more than £2,000, you can ask your pension scheme to pay the charge from your benefits. This means your pension scheme benefits would be reduced.
If the value of your pension pot you have built up exceeds £1,030,000 (2017/2018 tax year limit*****), you usually need to pay tax on the excess.
While most people aren’t affected by the lifetime allowance, you should take action if the value of your pension benefits is approaching, or above, the lifetime allowance
It may be necessary to take your pension early or stop contributing to the scheme/plan, even though you have not retired, to avoid your benefits exceeding the lifetime allowance.
How to check how much lifetime allowance you have used
Ask you pension provider how much of your lifetime allowance you’ve used (you can normally also find this on your annual statement).
But remember that if you’re in more than one pension scheme, you must add up what you’ve used in all pension schemes you belong to.
What counts towards your allowance depends on the type of pension pot you get:
Defined contribution: money in pension pots that you are entitled to, regardless how you decide to take the money
Defined benefit: usually 20 times the pension you get in the first year plus your lump sum
Specific protection for high value pension pots was introduced in April 2016 when the Annual Allowance was reduced from £1.25m to £1m, but these are beyond today's scope.
Tax due if you exceed the annual allowance
You’ll get a statement from your pension provider telling you how much tax you owe if you go above your lifetime allowance. Your pension provider will deduct the tax before you start getting your pension.
The rate of tax you pay on pension savings above your lifetime allowance depends on how the money is paid to you - the rates are:
55%if you get it as a lump sum
25% if you get it any other way, for example pension payments or cash withdrawals
If you want to find out more about the Taxation of Pensions, the following websites provide useful information:
The Pensions Advisory Service
If you want to discuss any of the above in more detail, please get in touch
* we are not considering State Pension in today's blog, which is built up through National Insurance Contributions
** The annual allowance applies across all of the schemes you belong to, it’s not a ‘per scheme’ limit. Also note that if you have already started drawing a pension, a lower limit of £4,000 might apply
*** these calculations can be quite complex. Ask for professional advice from your accountant if you need it
**** some pension schemes also allow payments to be made into an employee's pension scheme by persons who are not the employee or their employer
***** from April 2018 the lifetime allowance will be indexed year on year in line with the Consumer Price Index.