A pension is a sum you receive after you have retired, usually on a regular basis, which counts as your taxable income when you receive it. A pension may be given to you, you may earn it as part of your reward for working or you may contribute to a fund that will pay you later.
Pensions is a very big subject, usually advised on and operated with the assistance of a financial advisor. There are also big tax breaks and some complicated tax rules hence the involvement of an Accountant. This blog is just some basics.
Over your working life your wages and self-employed earnings are subject to national insurance. If over a certain level, then each pay packet also earns you credits towards a state pension.
Currently your state pension is based on the number of years you have full credits. Until recently you were also entitled to a higher state pension (the state earnings related pension scheme – SERPS) depending on the level of nation insurance you paid but this has ceased with benefits being phased out.
Credits may also be awarded without earnings e.g. if you are on job seekers or in receipt of child benefit.
Company or Occupational Pension
In the past many companies as well as government bodies included as part of an employee’s salary package an entitlement to a pension based on final salary at that employment. It was then the employers responsibility to maintain a fund big enough to honour this commitment.
These have become very valuable, but also expensive to maintain so few companies still offer them, although they are common for teachers, doctors and government officials. But also, as they have become valuable, so they have become the target of HMRC rule changes, as well as scams.
If you have one of these big valuable final salary pensions, then talking to a reputable independent financial advisor is key to keeping those valuable benefits, and not suffering penalty taxes by taking the wrong action.
There are many terms for this type of pension but essentially it is a pension pot with your name on it. Anyone can put money in, but from day one you are entitled to the whole pot, less of course taxes and fees.
As SERPS has been closed so the government have insisted that employers provide pension schemes to their staff. Initially this was by employees choosing to opt into a stakeholder pension scheme, but this has been replaced by compulsory automatic enrolment with employees then able to opt out.
These auto-enrolment schemes also have compulsory minimum levels of contributions for those employees who do not opt out.
Tax Rules for Pensions
There are three big rules for making contributions to your pension
- Tax relief
Pension contributions are eligible for tax relief.
An employer may make contributions direct to your fund, tax free as part of your salary package.
You or a third party may make pension contributions to your fund that are then eligible for income tax relief in one of two ways:-
- Basic rate relief at source, claimed by the pension company and added to your pension fund
- Full or higher rate relief via your personal tax return
This income tax relief is limited to the higher of your earnings (i.e. wages and self-employed profits) in that tax year, and £3,600
Excess contributions need to pay back any tax relief obtained at source by the pension company, via your tax return.
- Annual Charge
There is a limit on the total amount that may be contributed to your pension fund in any year. If exceeded, then the excess is subject to the “annual charge” i.e. is added to your income for that year and taxed via your tax return.
There are many elements to this total contribution limit
- The Annual Allowance (AA) – a basic limit of £40,000 per annum 2017-2021
- The Money Purchase Annual Allowance (MPAA) – a reduced limit if you have drawn money from your pension – currently £4,000
- Taper – if your income is over a certain level then your AA may be reduced, maybe to as low as £4,000
- Unused AA or Tapered AA (But not MPAA) sits around for 3 years and is available as carry forward to use if AA has been exhausted.
- Lifetime Allowance
The tax man has set a limit on how much you can put away tax free for your pension.
Every time you make a contribution (or have a pay rise if it is an occupational pension) this increases the total value of monies you have in pension funds. When you start to draw your pension then the lifetime limit is reviewed at each drawdown.
If the total value of the funds exceeds your lifetime allowance then a 55% tax charge is levied on the excess if taken out as a lump sum or 25% plus income tax if taken as income e.g. an annuity
Specifically, additional contributions once your lifetime limit has been met can destroy any protection you may have put in place
When you take your pension, 25% is tax free and the balance pays usual income taxes.