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Tax on Pensions

This is the second part of two articles on Pension Tax, you may wish to read Tax on Pensions Part 1 first.

Annual allowance

You usually pay tax if savings in your pension pots go above the annual allowance. This is currently set at £40,000 a year. You can carry over any allowance you did not use from the previous 3 tax years. You need to carry over unused allowance from the earliest tax year first.

The tax year 6 April 2015 to 5 April 2016 was split into 2 periods with different tax-free allowances.

Pension Annual Tax Allowance

Period

Annual allowance

6 April 2015 to 8 July 2015 (the ‘pre-alignment tax year’)

£80,000

9 July 2015 to 5 April 2016 (the ‘post-alignment tax year’)

£0

You can carry over up to £40,000 of unused allowance from the pre-alignment tax year to use in the post-alignment tax year. You can carry over any remaining unused annual allowance to later tax years. The allowance was £40,000 for the 2016 to 2017 and 2017 to 2018 tax years.

Lower allowance if you take money from a pension pot

Sometimes it’s possible to keep paying in after you take money out of a pension pot - but you may have to pay tax on contributions over £4,000 a year.

That’s because your annual allowance drops to £4,000 for all defined contribution schemes you’re in. It drops in the first full tax year after you take money from your pension pot.

The lower allowance is called the ‘money purchase annual allowance’. You cannot top it up with unused allowance from previous years.

Pre-alignment tax year

(6 April to 8 July 2015), this money purchase annual allowance is £20,000.

Post-alignment tax year

(9 July 2015 to 5 April 2016) does not have its own money purchase annual allowance, but you can bring over up to £10,000 of the allowance from the pre-alignment year.

Withdrawal types that make your annual allowance drop

Your annual allowance drops when you take any of the following from a defined contribution scheme:

  • Cash or a short-term annuity from a flexi-access drawdown fund
  • Cash from pension pots, pension lump sums
  • More than the limit from a capped drawdown fund

The annual allowance also drops to £4,000 in some other situations:

  • Your pension provider sends you a ‘flexible access statement’ to tell you when this happens.
  • If your allowance drops to £4,000 for one of your pension pots, you must tell other pension schemes you’re in within 13 weeks

Going over the lower allowance

Your annual allowance also drops to £36,000 for all defined benefit pension pots you’re in. You can usually top this up with unused allowance from the previous 3 tax years.

If you go over the pre-alignment tax year’s £20,000 allowance, that year’s annual allowance for defined benefit pensions changes to £60,000. You can carry over up to £30,000 of this, but the rules are complicated. It’s advisable to speak to a tax or pensions professional to check.

High incomes – Reduced allowance

From April 2016 you’ll have a reduced (‘tapered’) annual allowance if both the following apply:

  • If your ‘threshold income’ is over £110,000 - this is your income excluding any pension contributions (unless they’re paid as a salary sacrifice by your employer)
  • If your ‘adjusted income’ is over £150,000 - this is your income added to any pension contributions you or your employer make

Lifetime allowance

You usually pay tax if your pension pots are worth more than the lifetime allowance. This is currently set at £1.03 million.

You might be able to protect your pension pot from reductions to the lifetime allowance.

In order to check how much lifetime allowance you’ve used you need to ask your pension provider how much of your lifetime allowance you’ve used.

If you have more than one pension scheme, you must add up what you’ve used in all pension schemes you belong to.

What counts towards your allowance depends on the type of pension pot you get.  

Understanding Pension Lifetime Allowance

Type of pension pot

What counts towards your lifetime allowance

Defined Contribution - personal, stakeholder and most workplace schemes

Money in pension pots that goes towards paying you, however you decide to take the money 

Defined benefit - some workplace schemes

Usually 20 times the pension you get in the first year plus your lump sum - check with your pension provider

You may have to provide information about other pension schemes you’re in to check if you’re above your lifetime allowance if you:

  • Decide to take money from a pension pot
  • Turn 75
  • Transfer your pension overseas

If you go above your lifetime allowance your pension provider will deduct the tax before you start getting your pension.

You’ll need to report the tax deducted by filling in a SATR.

Rates

The rate of tax you pay on pension savings above your lifetime allowance depends on how the money is paid to you - the rate is:

  • 55% if you get it as a lump sum
  • 25% if you get it any other way, for example pension payments or cash withdrawals

Withdrawing cash from a pension pot

You cannot withdraw cash from a defined contribution pension pot if you have:

  • Primary or enhanced protection covering a lump sum worth more than £375,000
  • ‘Lifetime allowance enhancement factor’ if your unused lifetime allowance is less than 25% of the cash you want to withdraw

Report any changes to HMRC

It’s possible to lose enhanced protection or any type of fixed protection if:

  • You make new savings in a pension scheme
  • You are enrolled in a new workplace pension scheme
  • You transfer money between pension schemes in a way that does not meet the transfer rules
  • You’ve got enhanced protection and, when you take your pension benefits, their value has increased more than the amount allowed in the enhanced protection tax rules - this is called ‘relevant benefit accrual’
  • You’ve got fixed protection and the value of your pension pot in any tax year grows at a higher rate than is allowed by the tax rules - this is called ‘benefit accrual’

You need to check with your employer whether they’re likely to enrol you in a workplace pension. To make sure you do not lose protection, you can either:

  • Opt out of most schemes within a month
  • Ask not to be enrolled in some schemes - your employer may need evidence of your lifetime allowance protection