Income tax, VAT, tax returns, – these are all terms that tend to trigger negativity, fear and even aggression. For many, the tax office is a villainous institution which is going to try to take as much money as it can – and probably unfairly. Well, fair or not, it is something we all have to budget for – it’s perhaps a pity taxation is perpetually considered the bad guy, because in many ways it pays for the comforts in life, we often take for granted. But perhaps surprisingly, in the world of pensions, the tax man gives a lot back directly to the saver as well. The key to making tax work for you when saving long-term is understanding the basics of how this works.
With an aging population in the 21st century, the UK government knows it cannot fund everyone with a satisfactory State Pension. Therefore, there are two main ways in which it encourages working people to take out a private pension.
It may be that you still wish to contribute to your pension even if you are not receiving a regular salary. You will still receive tax relief on your contributions (up to £2,880).
Tax relief and yearly allowance
There is an annual cap on how much tax relief you can receive on your pension within a twelve-month period. This is called the Money Purchase Annual Allowance (MPAA). This is the maximum amount that you and your employer can contribute to your pension fund, once you have started to withdraw from it. Currently, this is set at £10,000 per year. The ultimate cut-off point for tax relief, if you are not currently withdrawing funds from your pension, is £60,000 a year, or equal to your annual salary, whichever is smaller. If you are on a high income (rather than an income where you are taxed at 20%) your allowance will be higher than £60,000.
An example
As stated above, the amount of tax relief you receive is dependent upon the income tax rate you are paying. (Tax is dependent on individual circumstances and is subject to change.) Salaries of up to £40,000 a year are at 20% basic rate tax (the average for the working man or woman in the UK). This is seen in real terms when you actually contribute to your pension. For instance, if you want to contribute £10 you only have to find £8 because the government will give you £2 in the form of tax relief (20%).
It is important that you do not contribute more than 100% of your yearly salary. You will be taxed on any amount above this. So be careful as HM Revenue and Customs (HMRC) can ask you to pay it back in tax.
State Pension and personal allowance
Your personal allowance is the amount you can earn in any one year without paying tax. The standard personal allowance is currently £12,570. If your yearly income comes above this, you will pay tax on your State Pension. Your yearly income may be increased by other benefits (such as Marriage allowance), interest from savings and investments, or salaries you receive even though you have retired.
In the majority of scenarios, like the one outlined above, you will be given tax relief at source – even where income tax may be at 19% (parts of Scotland) and with some overseas pensions, but you will need to claim if:
You can claim either through a self-assessment tax return or by contacting the HMRC directly
Any extra money you receive has the potential of being taxed because it adds to your yearly income. Consequently, any funds you take from your pension are likely to be taxed. However, it’s not all bad news. By accessing your pension wisely, you can avoid paying too much tax (note: tax avoidance is not illegal – it is “the arrangement of one’s financial affairs to minimise tax liability within the law.” It is tax evasion – the conscious decision to ignore a country’s taxation regulations, which is illegal). In the world of pensions this comes down to understanding the rules and accessing your fund in a way that will attract the least taxation.
It has to be said that accessing your pension is not right for everyone. Taking money from your fund will lead to a depletion in savings available for your retirement. It is therefore recommended that you seek the advice of a regulated financial adviser to consider your best options.
If you decide to take money from your pension savings after the age of 55, there are ways to avoid paying too much tax. It is good to know that the first 25% of money you take from any one of your funds will be tax-free. Therefore, it stands to reason that by modifying how you access your pension can reduce your tax burden.
For instance, taking your pension in small chunks and monitoring how much is accessed is essential. Also, if you are considering taking your pension early you can use pension drawdown. This means you can have a regular income while the main body of your pension remains invested.
In most cases, you can usually take up to 25% of your pension tax-free. Anything above this will be taxed at your marginal rate. (Tax is dependent on individual circumstances and is subject to change.) That’s why it makes sense to speak to a financial adviser, such as Pension Access, before you make any final decisions.
In normal circumstances we expect the taxman to be taking money away. However, in the world of pensions there are many ways in which we are rewarded with tax relief. In order to make sure that we pay the minimum tax on contributions and on any monies accessed from our pension funds, it is important to understand how tax regulations work. It is also recommended to seek the guidance of a regulated financial adviser.
We can help you to make the best possible decisions when it comes to your pension.
