There are two distinct tax advantages when paying into a pension; tax relief on pension contributions and the rules around passing on of pension wealth to beneficiaries.
Tax relief is available on pension payments at a person’s nominal rate of income tax. So, when someone on standard rate tax pays 80p into their pension, their pension scheme will claim 20p tax relief, giving a £1 contribution. Over the length of the pension that can significantly add not just to the amount of money saved but also the growth potential of the retirement pot. Higher rate tax payers receive 40% tax relief but have to claim the additional tax back via their income tax return. Tax is paid on the income received from a pension.
The new death benefits rules, introduced with the pension freedoms in 2015, enable pensions to be passed on tax free to any nominated beneficiary where death occurs under age 75. After that age the beneficiary will pay tax on the income received from the pension at their nominal rate of income tax.
These two benefits alone mean it can make very good sense to pay in as much as possible into your pension if you are able to do so.
Annual Allowance rules
Paying into your pension must be done within the Annual Allowance rules; this limits the value of the pension payments a person can make each year, as well as the Lifetime Allowance, which limits the total amount a person can save into their combined pensions.
The Annual Allowance for 2019/2020 tax year is £40,000 but if you have not paid in the full amount in the previous three years you can carry any of those amounts forward for use in this tax year. If you don’t use it within three years you lose it.
The Annual Allowance covers your contributions into your pension as well as any employer contributions. For anyone with an annual income over £150,000, the Annual Allowance is tapered down to a minimum of £10,000 a year.
It is important to note that anyone who has started to draw from their pension is limited to paying in £4,000 a year. This was introduced to stop people drawing from their pension and paying the money back in, thereby benefiting twice from tax relief.
Lifetime Allowance rules
The Lifetime Allowance restricts the total value an individual may hold across any pensions they have to a set amount, currently £1,055,000. A tax penalty is imposed where pensions contributions exceed that amount. Where the excess money is drawn as cash, the charge is 55%; where it is taken as income it is 25%, no matter what the individual’s marginal rate of income tax.
Instances where people can get caught out with the Lifetime Allowance are where they have more than one pension accumulating capital over their working life; where they are near to the limit and fail to opt-out of auto enrolment; and where they have a mix of final salary and personal pensions, which are valued in different ways for Lifetime Allowance calculations.
If you would like advice on paying into or drawing money out of a pension tax efficiently, or to discover how financial planning can answer questions like:
“Can I retire and still afford to do the things I enjoy?”
“How can I pass on my pension wealth to beneficiaries?”
It's essential that you review your pension situation regularly; even if retirement isn’t far away, there are steps you can take to increase your retirement income. To arrange a free initial consultation with a Lowes Consultant:
Call: 0191 281 8811
The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.