As a pensioner, you have considerable control over your pension savings. There is increased flexibility around when you can take money out of your pension pot and the amount you can get at any one time. The changes to pension regulations apply from age 55 and have given many people a great deal of financial freedom.
But it is our responsibility to highlight all the possible repercussions from your decision. And they aren’t all positive. You need to think about your entire financial situation to make sure you don’t lose out by rushing into a decision. Careful consideration now ensures that you can achieve your plans and remain at maximum tax efficiency.
How do flexible pensions work?
This ‘flexible pension’ idea is still relatively new, it started on 6th April 2015. The idea is simple – you can take whatever amount you want out of your pension savings pot, whenever you want to. The main proviso is that you have reached the minimum pension age, this is 55 for most people. There are some exceptions for particular public service jobs and a few other professions.
These new regulations apply to ‘money purchase’ or ‘defined contribution’ pensions, where you have saved up a lump sum.
It is incredibly important to know that, while this is the essence of government regulations, they are interpreted differently by each pension provider. They all have their own version of the rules and you need to be au fait with yours in order to make the best decisions. Pension companies are not obliged to offer a ‘take however much you want, whenever you want’ policy. The new regulations just mean that they can.
Can I still get a regular income from my pension?
You can get a regular income from your pension savings by using them to buy an annuity from an insurance company. They will then pay you a “guaranteed income”. This is still possible under the new flexible pension regulations.
You can use part of your drawn down lump sum to buy an annuity policy that gives you a regular payment and do what you want with the rest.
It is important to note that there is no flexibility within an annuity policy once you have set it up. That’s why there are different types of annuity policy, to suit different people’s requirements.
You can get annuity policies that work in the following ways:
- Payments are made during your lifetime
- Payments continue after you die and go to your partner or spouse
- Payments are not for life, but just for a shorter, set period of time
- When you die, the policy ends
- After your death, a beneficiary can be paid part of the money
Payments from annuity policies are classed as income by HMRC, therefore they are taxable. Inherited annuity payments may be non-taxable.
Are final salary pensions also flexible?
Final salary pensions, or ‘defined benefits’ pensions, are a particular kind of workplace pension benefit calculated on how long you worked for that employer and how much you earned. These factors are used to work out how much pension you actually get by each specific pension provider.
The rules for these types of pensions are more restrictive.
- Public sector defined benefit schemes are very unlikely to allow you to move to a defined contribution scheme.
- Private sector switching is more likely, but still not a given. It is more likely if the transfer value is under £30,000.
- If you’re already receiving pension payments, you will not be able to move to another scheme.
- A very small amount of defined pension benefit may be able to be paid to you as a lump sum using the ‘trivial commutation’ regulation.
You need to think carefully and get sound professional advice before making any decisions about your final salary pension.
But what else is there to think about?
The temptation of releasing a substantial amount of money and the dreams of what you can do with it is strong. And the process can be relatively simple, if you have a straightforward set of rules from your pension provider.
But, it can affect the entirety of your short and long term financial future.
You need to think about:
- Current personal circumstances
- Current financial position
- Other investments and how they are behaving
- Future plans
- Charges you might have to pay if you take your pension early
- State benefits, universal credit, tax credits and your overall tax efficiency
Don’t make this decision recklessly, now is not the time to throw caution to the wind. Give yourself time to consult a professional and think through all the possible ramifications.
Many of these points are entirely personal to you and not for us to comment on. But we do know about the different consequences your pension decisions can have for your tax efficiency.
Tax efficiency and your pension
How do pensions get taxed?
This depends on whether it’s a lump sum, monthly payments and on other factors, like if you are still working.
25% of your pension can usually be taken out tax free. But the other 75% is taxable as income.
Flexible pensions have two options. You can take your whole pension pot amount at once and pay tax on all future payments. Or, you can stagger your payments which will each be 25% tax free and 75% taxed.
The possible fallout of this is where it puts you in terms of your tax bracket. You won’t just be paying more tax. And nobody wants to waste their hard earned pension money on an unnecessary tax bill. But if your taxable pension income puts you in the Higher Rate or Additional Rate tax band, it’s going to affect the tax allowances you are entitled to, like the Marriage Allowance and Child Benefit.
Also bear in mind the further complication that England and Northern Ireland, Wales and Scotland all have their own income tax systems. Particularly if you live in Scotland, the different tiers of tax bands can add some extra confusion.
This is why it’s important to work through all the sums for all the possible outcomes before you finalise your decision.
How is the tax on my pension calculated?
This is not as straightforward as you might expect. The flexibility aspect of pension pot access throws a lot of variables into the ring that have to be accounted for by HMRC. Most people pay tax on their pension through the PAYE system. This means that your pension provider deducts the tax before you see any money, just like an employer with income tax and NICs. Good news – no NICs are payable on pension income, only tax.
You might only have to pay tax on a portion of your pension, depending on how you intend to use your tax free lump sum.
The way it is taxed is influenced by:
- If you get the state pension
- If you still get other PAYE income
- If you take your entire pension pot at once, or only part of it.
Your pension provider uses the PAYE emergency tax code, or ‘month 1/week 1’, to work out a monthly tax bill on your pension income.
Emergency code pension calculation
- Deduct £1,042: this is your tax free Personal Allowance ÷ 12 months. (2020-21 Personal Allowance is £12,500.)
- Tax next £3,125 at 20%: this is basic rate income ceiling ÷ 12 months. (2020-21 Basic rate income ceiling is £37,500
- Tax next £9,375 at 40%: £112,500 (Higher rate tax band threshold) ÷ 12 months.
- Tax anything over £13,542 at 45 %. In line with Additional Rate tax band.
These numbers are for England and Wales. Scotland uses the same formula, based on their own income tax band figures.
Yes, it’s definitely complicated. Luckily you don’t have to work this out yourself. But it is important to understand where the calculation comes from, so you can keep a check on whether or not you’ve paid too much tax on your pension income.
Can’t the pension provider use my actual tax code?
If you have a P45 from your employer or another pension provider, then you can give this to your pension company and they will use this code instead of the emergency code. You will get a P45 from a pension provider if you take out your full lump sum at one time.
Could my pension tax bill be wrong?
Yes, you could end up paying too much or too little tax on your pension income. That’s why you need to be aware of the details.
Examples:
- If you’ve used some of your Personal Allowance for the year already and your pension provider calculates your pension tax bill based on the full amount, then you will have paid too little tax to HMRC.
- You could pay too much tax on your pension income if the higher or additional rates are applied incorrectly.
So how do I reclaim a pension tax overpayment?
There are two answers to this. One applies to people that have taken their full pension pot at once. The other is for those that have only taken a partial lump sum.
Full pension pot
You can get any overpaid tax back during the same tax year whether you do an annual Self Assessment tax return or pay through PAYE. The P45 you get form your pension provider becomes part of the evidence to support your claim.
HMRC have a plethora of forms to match the different financial circumstances of their customers. You need to figure out which one fits your situation and apply using the correct form.
- P50: you are retired, are no longer earning, just get your state pension
- P50Z: you have emptied your pension pot and have no income
- P53: you’ve got your pension lump sum using the ‘small pots’ regulations
- P53Z: you’ve got your full lump sum and still have other PAYE income
Flexibly accessed part of your pension pot
If you have regular payments or a sequence of irregular payments from your pension pot, the PAYE tax refund rules apply. So you might get some of your tax refund back alongside your next payment, if it’s in the same tax year. This is because HMRC will issue your pension provider with a different tax code for them to use with any further payments. The P45 situation doesn’t apply because you have money left in the pot.
You’ll need Form P55 to make an overpayment claim if you aren’t getting any more payments in the same tax year.
Don’t HMRC just work all this tax stuff out?
HMRC do reconcile all PAYE records at the end of a tax year and send you a ‘P800 calculation’ to inform you if you haven’t’ paid the right amount of tax. This includes taxpayers that have paid too much tax.
But no system is 100% and mistakes are sometimes made. It’s worth being on top of your situation yourself, so you can double check HMRC’s conclusions about your tax position. Remember, HMRC are the regulatory and administrative body for the tax system, but you are responsible for making sure you pay the right amount of tax.
I usually complete a self assessment tax return, do I just include my pension payments on that?
Yes, you need to put the taxable amount of your pension pot lump sum in the correct section of your self assessment tax return. You must also include the information from any PAYE refund forms that you may have used to claim during the tax year.
It’s worth noting that the impact of your pension income on your overall earnings, might mean that you have to use a self assessment tax return for the first time. For example, if your total income exceeds certain amounts. It’s wise to seek professional advice if this is your circumstance.
If you are still employed and are a higher rate tax payer its worth considering if you are entitled to higher rate pension tax relief. A refund can be backdated for the last four tax years if you are.
Being non resident and your UK pension income
If you are not living in the UK and are receiving or looking to receive either government and or private pension income from the UK you need to review your tax position both in the country you are living in and the UK.
As an expat it’s important to get it right because you can overpay tax in the UK or the country or your residence. Double taxation treaties exist between the UK and many countries throughout the world. The double taxation treaties vary and it’s important to make sure you understand what pension income in the UK you should be paying tax on.
How can other aspects of my financial life be affected by my flexible pension arrangements?
This is a very sensible question. And one you need to know all the answers to before you draw down any money from your pension pot.
These are some of the potential tax and benefit consequences of using your flexible pension pot:
Means tested state benefits
This includes pension credits, council tax reduction and universal credit. The action you take now regarding your pension affects both your current and future entitlements.
Your entitlement to means tested state benefits is partly based on your income and capital. A regular pension payment can be seen as income. And a cash lump sum from your pension pot partial or total can be deemed capital. Your whole financial picture is considered and your pension could reduce your entitlement to these kinds of benefits.
What you use a lump sum for is also something that will be taken into consideration by the DWP. You could be seen as ‘depriving yourself’ of pension income if you use the money to help out with your child’s house deposit, or to pay for care. The DWP could decide that you chose to give the money away and therefore are not entitled to state benefits.
Tax Credits
Tax credits are calculated on an annual basis, using your yearly income figures and tax rates. If your income goes under or over set boundaries, your tax credits will go up or down. Pension income is added into the overall income calculation that tax credits are based on. This doesn’t include any tax-free portion of your pension lump sum or regular payments.
So there is the possibility that your pension income amount will take you over the tax credit boundaries. This means that you owe some tax credits back to HMRC because they have paid you too much. And you will probably be entitled to fewer tax credits in the next year. This means that it’s probably worth getting in touch with the Tax Credit Office before the end of the tax year. You’re not obliged to, but it might prevent a larger tax credit for you to pay.
Child Benefit
Child benefit is not means tested, but there is a ‘high income child benefit charge’ (HIBC) that might come into play for you when you receive a large pension payout. If your pension pot takes your income over £50,000, this HICBC will be payable on all your child benefit payments for that entire tax year. Just something else to bear in mind when you’re doing your personal calculations.
If I take money from one pension, can I still pay into another pension scheme?
You can continue to pay into a pension scheme after taking taxable money purchase pension benefits if:
- You are under 75 years old
- Are resident in the UK
- Have earnings or pay in an annual gross maximum of £3,600
But, if you’ve already got money purchase pension benefits, you can only pay in £4,000 a year and the amount of tax relief you ca get goes down. This is because you’re now triggering the Money Purchase Annual Allowance (MPAA). The MPAA applies to defined contribution pensions but not to defined benefit pension schemes.
MPAA rules apply if:
- You’ve taken your whole lump sum
- You take irregular lump sums out of your pension
- Your income could decrease because you bought a flexible or investment linked annuity
- You take income from the flexible access drawdown scheme you put your lump sum into
- You take payments from a capped drawdown plan that go over the ceiling amount (these schemes are dated pre-April 2015)
MPAA rules don’t apply if:
- Your pension pot lump sum is worth less than £10,000
- You buy a lifetime annuity with your tax free lump sum that gives you a level or increasing income for life
- You get a flexi-access drawdown scheme with your cash free lump sum and do not take an income from it
Extra note
You have to tell other pension providers that you are using MPAA rules and HMRC can fine you if you fail to do so.
So when should I cash in my pension pot?
That’s the $64,000 question. And one that everyone has to answer for themselves. We can’t give you a general answer to this question. Mainly because everyone’s situation is unique. No matter how much you think you’re in the same position as a colleague or friend, you need to make pension decisions on your own terms. There is no one best age or best time to cash in your pension pot. But you can find the best, most tax efficient time for you.
You need to arm yourself with all the information we’ve listed here and consider all the consequences of each variable. For example, just waiting a couple of more years until you stop work could end up saving you thousands in tax. Do the hard sums. Get professional advice and speak to HMRC. Carefully consider your options.
And then, whatever you do, make sure you enjoy the retirement you’ve earned.
