Understanding the pension tax rules could save you a big headache in the long run.
Pension saving is one of the best ways to protect your wealth from the taxman. You can boost your pension saving with generous tax relief and protect your wealth from capital gains tax and dividend tax. But the pension rules are complicated and it’s also possible to accidentally trigger a big tax charge, or not fully make use of pension tax relief available.
Here is a rundown of three big pension tax mistakes you could make and how to avoid them.
1) Not claiming a pension tax rebate
If you pay into a workplace pension, then pension tax relief is usually simple. Most workplace pensions pay your contribution directly into your pension pot before tax is taken. This means that it only costs you £80 to pay £100 into your pension if you’re a basic-rate taxpayer, or £60 to pay in £100 if you’re a higher-rate taxpayer.
But the rules are slightly different if you pay into a private pension scheme such as a SIPP, or a workplace scheme that pays in your pension contributions after tax. All taxpayers get 20% tax relief added automatically to their pension payments. But higher-rate taxpayers won’t automatically get the extra 20% unless they fill in a tax return or write to HMRC at the end of the tax year. As a result of these complex rules, it’s estimated that at least £830 million in available tax relief is going unclaimed.
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If you’re a higher-rate taxpayer and you pay into a private pension, then check you’re receiving a tax rebate at the end of the year from HMRC. They will either adjust your tax code to reduce the tax you pay next year, or send you a cheque in the post.
2) Being too scared of the lifetime allowance
If the tax-free lump sum is one of the best-loved pension rules, then the lifetime allowance, or LTA, must be one of the most hated. It works by imposing an excess tax charge once your pension pot reaches the lifetime allowance limit, currently £1,073,100.
A pension pot of £1 million seems like a huge amount, but it may be possible to achieve it as even modest regular investments add up over time. For example, if you’re 45 years old, have a pension pot of £250,000 and pay £400 per month into your pension, you could breach the current lifetime allowance by the time you reach 70, assuming investment growth of 5%.
But there’s a risk that pensions savers are scared of the lifetime allowance excess tax charge and could actually end up worse-off because they avoid using their pension. In some cases, you may still be better off saving into a pension even if you breach the lifetime allowance.
First, it’s important to remember that the lifetime allowance tax charge only applies to amounts over the lifetime allowance limit. Someone who’s got £1,200,000 in their pension when it’s tested against the lifetime allowance rules, could end up with an additional £31,725 tax charge (£1,200,000 minus £1,073,100 x 25% tax charge). You’ll also be charged tax again when you come to draw your pension, giving a total tax charge of 55% on the excess amount if you’re a higher-rate taxpayer.
Second, your pension is only tested against the lifetime allowance at certain points. Checks are typically carried out:
- when you start drawing a defined benefit pension
- when you take an income or a lump sum from a defined contribution pension
- if you transfer a pension overseas before age 75
- if you reach 75 and have a pension in drawdown, or that you haven’t touched
- if you die before age 75 and have pensions you haven’t touched
After 75 years old, there are generally no more tests, although there are some circumstances where a charge may be due on death, so it’s worth getting advice.
Third, other pension rules mean that it may be worth paying into your pension, even if you breach the lifetime allowance rules. For example, if you earn £60,000 and work somewhere where you contribute 5% of your salary and your employer contributes 5% of your salary into your pension, it only costs you £60 to pay £200 into your pension (£100 employee contribution, which costs £60 after tax, £100 employer contribution). Even if that £200 later attracts a 55% tax charge, you would still end up with £90 from a contribution that originally cost you £60.
Ultimately, it’s important to get advice if you think you may be at risk of breaching the lifetime allowance rules. A financial adviser will be able to look at all your financial circumstances and give you tailored advice to help you minimise your tax bill.
3) Triggering the money purchase annual allowance
The money purchase annual allowance can trip up people who are starting to access their pension. The rules mean that anyone who starts taking an income from their pension has their annual pension allowance reduced from £40,000 to £4,000 and loses the ability to carry forward unused allowance from previous tax years.
The new £4,000 limit also includes amounts paid into your pension by your employer and pension tax relief, meaning that you can only pay a maximum of £333 per month (£4,000 per year) into your pension once you’ve triggered the rules. This rule can make it difficult for people who temporarily leave the workplace, or start to access their pension to supplement their income during a career break.
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It’s important to understand the rules and take care once you start to access your pension pot. Taking a tax-free lump sum won’t trigger the money purchase annual allowance rules but starting to take a taxable income will. Check here for more details on the rules.
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