Pensions offer very attractive tax benefits, especially the initial tax relief on contributions. However, there are rules restricting contributions and the size of your
pot (via taxes) as well as when and how you can get your hands on it.
How much can I contribute into my pension?
While you can contribute as much as you want each tax year, you'll only get tax relief on the greater of £3,600 and your annual earnings, subject to an annual
allowance (shown below). Earnings must be taxable in the UK and exclude investment income and gains, but normally include taxable benefits for employees. For the
self-employed earnings are usually profit after any adjustments.
|Annual Earnings Allowance for Pension Tax Relief
* This reduces if you earn over £110,000 a year and your combined earnings and pension contributions (called 'adjusted income') exceed £150,000 a year. Your allowance will reduce by £1 for every £2 your
adjusted incoem exceeds £150,000, subject to a minimum allowance of £10,000. Your allowance could also fall to £10,000 if you have already taken benefits from a pension.
Contributions that exceed the annual allowance will be taxed at the same rate of tax relief given on the contribution - effectively removing any tax relief.
If you have a final salary pension your contribution is deemed to be the increase in your annual pension benefits multiplied by 16.
When can I take my pension?
If you have a pension then the earliest you can take it is age 55.
Is there a limit on the size of my pension pot(s)?
Yes, in so far as you'll effectively be taxed at 55% on any of your pension that exceeds a 'lifetime allowance' when you either buy
an annuity, draw an income or die.
|Pension Funds Lifetime Allowance
Because final salary pensions don't have an actual fund value, it's assumed to be your annual pension multiplied by 20 for the purposes of the lifetime allowance.
The tax on any excess above the allowance is calculated by deducting a 25% 'recovery charge' and higher rate tax of 40%.
Mr Bigshot has a pension fund valued £100,000 above the lifetime allowance. The £100,000 suffers a 25% recovery charge leaving £75,000, falling to
after higher rate tax has been deducted.
How can I take my pension?
When you take your pension benefits there are two components: a tax-free lump sum and a taxable income.
Tax-Free CashAnnuitiesIncome DrawdownLump Sums (UFPLS)Small Pension Funds
When you take your pension benefits you can withdraw up to 25% of your pension fund as a tax-free lump sum.
If you have a final salary pension your fund doesn't have an explicit value, so a formula is used instead. To use the formula you need to know your pension schemes
'commutation rate', the amount of tax-free cash you'll receive for each £1 of pension that you give up. You can then calculate your entitlement as follows:
Maximum tax-free lump sum = 20 x Your Annual Pension / (3 + 20 / Commutation Rate).
You don't have to take any tax-free cash, but it's normally a good idea as the money will otherwise used to produce taxable income.
Once you've taken the tax-free cash you can either buy an annuity or leave your pension invested and draw an income.
This depends on your age when you die:
Die before age 75Die age 75 or over
Your pension fund can be paid to beneficiaries as either a tax-free lump sum, tax-free income or combination of the two. If you've already purchased an annuity then income will be paid tax-free to a
surviving spouse if you included that option when buying the annuity.
Here's some of the more common pension jargon you might come across:
|'A' Day||6 April 2006, the day the government pension simplification rules came into effect.
|Annual Earnings Allowance||The amount that you contribute into a pension each tax year and enjoy tax relief (capped at your annual earnings if lower).
|Income Drawdown||Leaving your pension fund invested when you retire and drawing an annual income within set limits.
|Lifetime Allowance||The amount your pension fund is allowed to be worth when you retire or die without having to pay a penalty tax.
|Small Pension Funds||Pension funds that do not exceed 1% of the lfetime allowance at retirement, allowing you to take the whole amount as a tax-free cash sum.
|Tax-Free Cash||The sum of cash you can take from your pension fund, tax-free, when you retire. Currently 25%.