Richard Curtis considers some income tax consequences pension payments.
The tax benefits of pension contributions are valuable but contributors will also need to consider the tax liabilities that arise when a pension is taken.
For this brief overview, I will focus on personal pensions (also known as defined contribution or money purchase schemes) where the amounts paid into the plan accumulate over the years with further tax-free income and capital growth from the fund investments.
When can the pension be taken?
Although the age at which a state pension can be taken is now 66, funds can generally be withdrawn from a personal pension plan from age 55. Note that the state pension age is gradually increasing and will be 67 in 2028, at which point the age threshold for taking funds from a personal pension will increase to 57 and will then be fixed at ten years below state pension age.
Withdrawals do not have to be taken at 55; the contributor may still be working and not need income from the fund. Further, the longer funds are held within the pension fund, the longer they benefit from tax-free growth and income, as well as (of course) further contributions.
Historically, the pension funds would be taken partly as a tax-free lump sum with the balance buying an annuity to pay an income for the life of the contributor and perhaps their spouse (which for the purposes of this article includes a civil partner). While this option remains, since 2015 there is much more flexibility.
Tax-free and taxable elements
The option to take 25% of the fund tax-free remains, although this no longer must be taken as a single payment. Withdrawals from the remainder of the fund will be treated as taxable income. The contributor still has the option to buy an annuity, but may choose instead to put the fund into ‘drawdown’ where they take the pension fund as income when and to what extent they choose. Such payments will be subject to income tax and the liability will depend on personal circumstances and other sources of income.
This provides flexibility. For example, someone with a state pension might also draw from their pension fund. If they subsequently returned to work, they might suspend these pension fund withdrawals, whereas once in place an annuity payment would continue throughout the contributor’s lifetime (and perhaps that of their spouse). Withdrawals might also be limited to an amount that would be subject to tax at only 20%.
On the other hand, the flexibility of the fund does mean that it could all be withdrawn at once, perhaps to buy a new car, house or exotic holiday. Remember, of course, that other than the 25% tax-free element, the rest will be taxed as income in the year of receipt, which could result in liability at 20%, 40% or 45% depending on the amount involved. Spreading payment over a period of years is therefore likely to result in a lower overall liability.
Allowances and inheritance
Although as indicated above there are advantages in being able to make flexible withdrawals from a pension, once income is taken the money purchase annual allowance will limit future tax-relievable pension contributions to £4,000 a year rather than the normal £40,000 annual allowance. A tax charge will arise if the limit is exceeded. Similarly, a charge may arise if the total value of all the contributor’s pension schemes (other than the state pension) exceeds the lifetime allowance of £1,073,100. Savers should be aware of these thresholds and take advice if they think they may be affected.
Practical tip
When making flexible withdrawals, consider the period over which these will deplete the pension fund, bearing in mind future financial commitments and income requirements as age increases.
