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Money Matters - Taxation of Pensions. "Not a free meal ticket"

View profile for Daniel Elkington
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After the success of the last five ‘money basics’ articles we are continuing this theme with a series of articles on focused subjects. The next five will be covering the overly complex subject of pensions in a little more detail.

So, we’ve covered off the topics of what Drawdown and what Annuity is, now onto the topic of taxation and a small section on UPFLS.

Limitations, Limitations…

The limits according to pensions are the Lifetime Allowance, the Annual Allowance and the Earnings allowance and I’ll cover off all three here. This is a very technical area of pensions law – I’d recommend a stiff cup of coffee and at least ten star jumps before reading. The Lifetime allowance is easily the hardest bit so I’ll do that last.

Earnings Allowance

You can pay in a gross amount of personal contributions to a pension equal to your UK Relevant Earnings. In most people’s case this means your salary.

If you earn £40K, you can pay in (gross) £40k.

You might do this if you are near retirement to get the tax relief, which would be £8K from the government in this case. You could even fund this with the money sat in the bank as with tax relief you are getting a return of 20% immediately.

Companies can make unlimited payments on behalf of their employees and get corporation tax relief – however the individual that benefits might suffer the next tax in order to do so:

Annual Allowance

Presently you can pay in £40K into a pension under the annual allowance and can use the past three years unused allowance.

This tax year there are, sort of, two annual allowances, but the detail of this is beyond this article.

So, you could use £40k for this year (17-18), £40K for 16-17, 15-16 and 14-15. A total of £160K as a gross contribution, although in practice very few need worry about this. Suffice it to say that those with decent earnings in a final salary scheme need to worry about the annual allowance, but most of us don’t.

If you breach the earnings allowance then HMRC ask for the tax-relief back. If you breach the annual allowance then the tax charge is a bit more complicated but is essentially taxed as earned income. So if you were earning £60K and went over the annual allowance by £10K then HMRC would want £4k off you.

The last allowance is the lifetime allowance. This is the hard part, brace yourselves. There is a really useful bit right at the end.

Lifetime Allowance

This is presently £1m; which is a lot for a single individual to have in a pension scheme.

Working out what the lifetime allowance is for you can be fairly tricky and relies on these things called Benefit Crystallisation Events (BCE).

Essentially, when you take any money out of pensions you have to test the value of the pot you are using against the lifetime allowance and each type of event is given a BCE number. If you want the detail google ‘RPSM11102020’.

Case study

So for personal pensions, you know the value of the pension – it’s written (sometimes hidden) on your statement. If you were taking £250K and buying drawdown with it from a £1m scheme in this tax year then you would have 75% of the lifetime allowance remaining as you ‘crystallised’ £250K, which is 25% of the lifetime allowance.

If you also had a final salary scheme worth £23,000 a year with a tax-free cash of £40,000. The calculation is to multiply the amount of income by 20 and the £40K of tax-free cash comes in as £40K. This would be tested as another £500,000 and would take 50% away, leaving you with 25%.

If you then hit age 75 with the remaining £750K, which had grown to £1.1m and the remaining drawdown pot was now £400K then you’d test the £1.1m + the growth in the drawdown scheme (£150K under BCE 5a and 5b.)

Assuming the Annual allowance had gone back to £1.5m at age 75, then you’d have 25% of the allowance remaining; £375K, yet were ‘crystallising’ £1.25m, so a charge might be levied  This will be at 55% if the pot is taken as cash and 25% if taken as an income. If the money is designated as ‘drawdown’ before age 75 then the charge would be 25% as drawdown is an ‘income’ product.

The nugget

The lifetime allowance is a lot cheaper than inheritance tax, paying 25% on your assets is a lot cheaper than paying 40% on death.

It may be painful, but is cheaper. There are other things that are taxed less than this however…

Sorry for the amount of technical stuff here, there really is a lot more of that so contact an IFA if you need some help working out what is best for you.

I promise the next one will be a lot nicer – what can you invest in!

Our in house Independent Financial Advisors can help you with all aspects of financial planning including pensions, investments and inheritance tax planning. If you need any legal advice, please contact the Chattertons’ Wealth Management team at your nearest office.

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