Many of you would have probably heard that pensions are highly tax efficient. Your savings and investments within a pension fund are not subject to either income tax or capital gains tax. This helps you to grow a nice healthy retirement pot for the future.
However, there are further tax implications to consider when taking money from your pension. Imagine a pension as a cake. Let’s say your pension is equivalent to taking a slice of cake. Cutting a quarter slice of this cake represents what is referred to as ‘tax free cash’. 25% of your pension can be taken free of tax. The remainder of the cake (75%) is treated as income. The same applies if you decide to take lump sum withdrawals. For example, for every £1,000 lump sum withdrawal. £250 would be tax free and £750 would be considered income and taxed at your marginal rate assuming you haven’t already used your tax free cash. The HMRC will calculate your income for that tax year and then determine what rate of tax is owed on the 75%.
When calculating your total income for the tax year, the taxman adds ALL of your sources of income together. Some examples of income include your salary, rental income received, savings interest, share dividends and private or state pensions.
Your income will then be taxed accordingly using a layered method. The first layer of income is tax free due to the personal allowance. Any income in excess of this will then pass into the basic rate tax layer and taxed at 20%. Any income in excess of this will pass into the higher rate tax layer which is taxed at 40%. Finally any income which surpasses the higher rate tax layer will be subject to 45% tax and in some situations even more!
Attention and careful planning is needed if you are considering taking lump sums from your pensions to ensure that you do not pay more tax than you had expected.
When you request a withdrawal from your pension company, they will try and calculate the amount of income tax from your lump sum and send it to HMRC. However, the pension company isn’t always aware of your other sources of income. The result of this is that you could end up paying too much tax or even not paying enough tax.
You can fill out a HMRC self-assessment tax return at the end of the tax year to find out if you have paid the correct amount of tax. Paying too much tax will result in a refund from HMRC and paying too little will mean you owe HMRC more tax.
The key thing to remember is that once any money leaves a pension, that money no longer benefits from the highly tax efficient pension rules. Reinvesting withdrawn money into other assets or depositing it into a bank account could subject the amount to other tax implications. In addition, money within a pension is sheltered from inheritance tax which is charge at a rate of up to 40% when you die.
Overall, it is important to understand the full tax implications when considering taking your money from your pension pot and have a plan in place to efficient access your retirement funds.