Savers: 10 key pension tax advantages and pitfalls
Financial security is the most common worry for savers thinking about retirement. Pension pots and retirement savings are often the biggest lump of money many will ever have access to, so it is important to understand all the options available to make the most informed decisions and avoid pitfalls.
Here Adrian Lowery, personal finance expert at Isa and Sipp platform Bestinvest, delves into 10 of the tax benefits and dangers pension savers need to know about along with Louise Higham, a chartered financial planner at Tilney, Smith & Williamson.
1. Don’t spurn free cash: make the most of pension tax reliefs
Tax relief boosts the value of your pension pot immediately, so cannot be ignored.
It is granted automatically at 20% of the amount going into your pension, while higher-rate taxpayers can claim back an extra 20% and additional rate taxpayers 25%, whether that is through their annual self-assessment tax return or automatically in their workplace pension.
If you pay £80 into a Self-Invested Personal Pension or workplace pension, that will be topped up to £100 whatever your marginal (or top) tax rate. Because £20 is the tax that a basic-rate payer would pay on £100. It’s worth noting here that your pot is boosted by 25% by the 20% tax relief (£20 being a quarter of £80).
A higher-rate (40%) taxpayer could then claim back another £20, while an additional-rate (45%) taxpayer could claim £25. The higher-rate taxpayer is getting £100 in their pension pot for a net cost of £60 after the tax reliefs. That is effectively a 66.7% return before any investment growth.
Workplace schemes vary in how they administer this, so some higher-rate taxpayers in company pensions and the majority of Sipp holders will have to take steps to claim back their extra tax relief.
2. You might be able to drop a tax band by upping pension contributions
At some companies the tax benefits could be even greater as they may allow employees to reduce salary or bonus payments in lieu of increased pension contributions.
'Salary sacrifice’ entails the employee agreeing to a lower gross income and the employer paying the difference into a pension alongside their usual contributions. Both employee and employer will as a result pay lower National Insurance contributions (NIC), which are set to rise in April, and this makes pension saving even more tax efficient.
Sometimes the employer might even pay some or all of their NIC saving into your pension.
“Moreover, if you are close to the £50,271 earnings threshold where the higher 40% tax rate kicks in, you could dip under it by using salary sacrifice pension contributions so you don’t end up paying excessive marginal tax,” says Higham.
“It sounds too good to turn down, but there are disadvantages to agreeing to a lower salary, such as affordability calculations when it comes to applying for a mortgage,” she adds.
“Employee benefits such as life cover, and holiday, sickness and maternity pay could also be affected. As could possibly, in the long term, one’s NIC record and state pension entitlement. Employers offering such schemes should provide you with personalised calculations of how it will affect your take-home pay and benefits, and how it will boost their contribution to your pension if at all.”
Read more: State pension age changes keep thousands more in paid work
3. Watch out for your allowances
Savers who are able to lock away their money until the minimum pension access age (currently 55) need to consider the fiscal advantages detailed above. But there are ceilings on what can be saved tax-free.
For most people the total sum of personal contributions, employer contributions and government tax relief received can’t exceed the annual personal allowance of £40,000 (2021/22). More rigid and complicated rules apply for the very highest earners under a tapering allowance that can reduce the annual allowance to as little as £10,000.
“And you can’t contribute more than 100% of your earnings to a pension during the tax year, so if your salary is lower than £40,000 then you are limited to contributing your annual earnings into pensions,” says Higham.
“Meanwhile the Lifetime Allowance (LTA) is the limit on how much you can build up in pension benefits over your lifetime while still enjoying the full tax benefits. Exceeding the standard LTA of £1,073,100 (as of 2021/22 – and frozen at that level until 2025/26), will lead to additional tax charges on the excess when you come to take your pension benefits or turn 75.”
4. Use carry forward to mop up unused past allowances
The pension annual allowance was £255,000 in 2010/11: as it is now £40,000, it is affecting a lot more savers than it used to.
Pensions 'carry' forward' rules allow you to use unused allowances from up to the three prior tax years in the current tax year - provided you have already maximised your current annual allowance and were a member of a pension scheme in the tax year you are carrying forward from.
Notionally, you could potentially carry forward up to £120,000 of unused allowances and add them to this year's £40,000 allowance. Tax relief would be applied at your current marginal rate and so carry forward can be particularly attractive to someone whose earnings have risen significantly.
“It is worth noting that you are still limited to 100% of your salary in the tax year you are making the contribution, regardless of how much you have available from previous allowances,” says Higham.
5. Tax-free pension access for older savers
The major drawback of pensions for some savers is that the money is locked away once committed. But up to 25% of your pot can be accessed tax free – with the remaining 75% available as taxable income - from private pension access age. That is currently 55, but set to rise to 57 from 2028.
This is certainly not to say that this is the right thing to do. But for savers aged 50 and over, the limits on access become less meaningful compared to the money benefits of saving into a pension.
6. Watch out for the money purchase annual allowance
Reforms introduce in 2015 – dubbed ‘pensions freedoms’ - mean today’s pension savers are no longer shoe-horned into buying an annuity with their pensions and have much greater flexibility in how they access their pension pots. But those planning to access their pension flexibly, either this tax year or next, need to think carefully about both the tax impact and the effect it will have on their ability to save further amounts into pensions in the future.
Anyone who makes a flexible withdrawal from their retirement pot beyond the 25% tax-free lump sum triggers the “money purchase annual allowance”. This permanently slashes their annual allowance from £40,000 to just £4,000, and revokes the privilege to carry forward unused allowances from previous tax years. This measure was introduced to stop people recycling money through pensions to benefit from extra tax-free cash.
Read more: Majority of Brits won’t be able to save in 2022 due to higher bills
7. Reclaim any overpaid tax on pension freedom withdrawals
When you take a flexible payment from your pension, HMRC assumes it is just the first of 12 monthly withdrawals. As a result this first flexible withdrawal from your pot is likely to be taxed at an emergency rate and will probably mean you are significantly overtaxed, potentially to the tune of thousands of pounds.
To get this money back you can do it through your self-assessment tax return, or by applying by form to HMRC online. Just search for form P55.
8. Watch out for the high-income child benefit tax charge
If you or your partner have registered for and claim child benefit, and one of you earns more than £50,000 a year, you will be liable for the high-income child benefit tax charge. This can be a major irritation for some couples as it needs to be paid through self-assessment.
The charge increases gradually depending on how much you earn. For those earning £60,000 or more, it equals the total amount of the child benefit.
This means lots of people choose not to claim child benefit – but by not claiming, you or your partner might miss out on National Insurance credits that count towards state pension entitlement.
“Therefore, if you are affected, the sensible option is to register for child benefit but opt to not receive it. So, you don’t have to pay the tax charge but still accumulate NI credits,” says Higham.
“This tax charge could also be avoided – while still legitimately claiming child benefit – if by using salary sacrifice for your pension contributions you take your gross earnings below the £50,000 threshold.”
9. Make sure your beneficiary is nominated
Pensions are an important part of tax and inheritance planning. If you die before age 75 your fund can be passed on to your beneficiary tax-free, while if you die after 75 it is taxed in the same way as income when your beneficiary draws an income. Furthermore, if your beneficiary dies before age 75 they too can pass on any untouched funds tax-free - even if you died after age 75.
Therefore, it’s essential that you arrange for your pension to go where you want it to – particularly as this can change according to your family circumstances.
“If no death benefit nomination is completed then your beneficiaries would only be able to receive your pension benefits as a lump sum,” says Higham.
“This can lead to quite a significant tax charge for your loved ones if anything happens to you after age 75. By completing a nomination form your loved ones will have options to take the pension to ensure this is taken as tax efficiently as possible based on their circumstances at the time.
“Nominating a pension beneficiary is usually something that can be done in a matter of seconds online and can result in a massive tax saving for your loved ones.”
10. Non-taxpayers can get tax relief
Even savers without earned income who don’t pay tax – such as a spouse who isn’t employed or children – can still pay into a pension and receive 20% tax relief. In this case, the ceiling on annual pension saving is £3,600, made up of your contribution of £2,880 and the taxman’s contribution of £720.
Watch: Is a UK state pension enough to survive on in retirement?
