Pensions and Tax

September 19, 2012

Tax is a concern before, during, and after pension benefits are paid: that is while investing into a pension scheme, when and while benefits are being taken, and after death.

Tax on payments into a pension scheme

Payments into a pension scheme receive tax relief at the basic rate of 20%. All payments up to the annual limit will have a tax credit added at the rate of 20%. This means that for every £80 paid into a pension scheme, the policy holder will have £100 added to his fund.

Higher rate taxpayers can claim back the difference between 20% and their marginal rate through their annual tax return.

All capital gains made within a pension fund are free of tax, and gains made within the fund may be tax free also.

Tax on the benefits of a pension scheme

A pension scheme holder may take up to 25% of his pension fund as a tax free lump sum. He may do with this lump sum as he wishes. He can spend it or save it, or invest it.

The balance of the fund is also taken tax free, but must be used to create an income. This is most commonly by way of annuity purchase.

Income produced from annuities or other pension income is added together and taxed as income. When calculating your taxable income, the following are also added to state pension and annuity income:

  • Income from savings and investments
  • Income from work
  • Income from taxable state benefits
  • Income from other pension schemes (e.g. defined benefit occupational schemes)

How your income will be taxed

Tax on income from company and personal pension schemes that is paid to you by the provider will have tax deducted at source, under the PAYE (pay as you earn) system. The HMRC will send the provider your tax code and tell them how much tax needs to be deducted. This calculation will include any tax due on your state pension.

You will receive a P60 at the end of the tax year which shows how much tax you will have paid and the amount of pension income paid to you.

If you are receiving income from other sources, for example other work, you will either have tax deducted on this income by your employer, or have to submit a tax return at the end of the year, including the details as received on your P60.

Tax will also be deducted from annuity income at source under PAYE.

It is important that you keep all tax documentation and enter a tax return at the end of each tax year. Many pensioners find that they receive tax rebates because of the way in which tax is deducted from income in retirement.

Tax allowances increase from the age of 65. If you haven’t received a form P161 to return to claim your age related allowance by your 65th birthday, then you should contact the HMRC, or download from the HMRC website to fill in and return. Whilst the age related allowance cuts the tax you are liable to pay, there is also an income limit at which point the age related allowance is cut by £1 for every £2 extra income earned, down to the basic personal allowance.

Tax on pension benefits after death

A widow, widower, or surviving civil partner of someone receiving the basic state pension may receive some state pension based upon the NI contributions that the dead partner had paid but only if they are not entitled to the basic state pension themself).

If you have contributed to the additional state pension (SERPS or S2P), then depending upon your date of birth, your surviving partner will be entitled to continue receiving these benefits between the rate of 50% and 100%.

Death benefits from a personal or company pension are often paid as discretionary benefits and therefore not subject to inheritance tax. Where the benefits paid are the return of contributions before a pension is drawn, they are returned free of income tax provided they are below the lifetime limit. Any excess is charged as to tax at 55%. Any dependant’s pension is taxable as income received by the beneficiary.

Lump sum benefits on benefits paid out because of death of a personal pension or stakeholder pension holder are not liable to tax provided the gross amount from all policies is below the lifetime limit. The excess is taxed at 55%. If the benefits are given as a pensionable income, then it will be taxed as income when in payment. If you die after you have started receiving pension benefits, then any income received by your surviving partner will be taxed as income in the normal way. However, if the benefit is paid as a lump sum, this will be subject to tax at 55%, and paid by the scheme administrator before payment of the lump sum is made.

In conclusion

Generally speaking, you receive tax benefits on payments into a pension scheme and incur tax liabilities when taking benefits. The level of tax liable will depend upon individual circumstances as well as the level of benefits and form of benefits received. When in receipt of pension income, particularly from more than one provider, it is always worth filing a tax return to claim any overpayment of tax through the PAYE system. If in any doubt, you should seek the advice of an independent tax specialist.