You want to be able to enjoy the same standard of living in retirement as you’ve had in your working years. And that’s achievable, if you plan well enough for retirement in advance.
Taxes, as Benjamin Franklin sagely noted, are one of the two things that can be said to be certainties in this world – and it’s very important that you’re aware that your pension is taxable too.
But there are ways to plan ahead and enjoy your nest egg to its fullest.
Read on to learn more.
The three main ways to access your pension
There are three main ways to access your pension: Annuities, Drawdown or Lump Sums (UFPLS).
Annuities – An annuity is a product designed to provide you with a guaranteed income when you retire. The majority are for life but there are annuities which run over a set period.
Drawdown – Drawdown is where you withdraw funds from your pension pot to live on. Many people find drawdown an attractive option due to flexibility it can offer. Recent changes to pension rules mean that you can keep your pension invested and withdraw a certain amount from your pot on a regular basis. The income you take will be taxed in the same way as employment income.
Lump Sums – An Uncrystallised Funds Pension Lump Sum (UFPLS) allows pension holders to withdraw some or all of their funds as a lump sum. If you’re planning to use this money to live on, you’ll need to make sure it lasts for as long as you need it to. You may also be able to take some smaller cash payments and spread them over a number of years.
You can mix and match these options, which could help you find the right balance of security and flexibility.
How are pensions taxed?
Your pension income is normally treated as earned income for income tax purposes, although it is thankfully not subject to National Insurance contributions.
The tax due may be deducted at source by your pension provider and paid to HM Revenue & Customs (HMRC) on your behalf.
So, how are the three main pension options taxed?
Annuities and drawdown funds will both be treated as taxable income.
25% of a lump sum (UFPLS) will be paid tax free, with the balance taxed as pension income at the point of withdrawal. Bear in mind that, the more cash you take out of your plan, the more you may end up paying in tax.
Pension rules used to be fairly stringent, but – following changes introduced in April 2015 – you now have much more choice and flexibility about how and when you can take money from your pension pot. This means that there are more opportunities to plan ahead and manage taxes.
How much tax will you pay on your pension?
The amount of income tax you pay depends on your gross taxable income.
You do not pay any income tax if your gross income does not exceed your personal allowance. For instance, the standard personal allowance for the tax year 2020/21 is £12,500. HMRC will tell you how much your personal allowance every time that figure changes.
If your gross income exceeds your personal allowance, you are liable to pay income tax on the amount that exceeds the personal allowance.
The rate of income tax will depend on the type of income and how much it comes to.
Your pension provider will usually calculate how much tax you are liable for, and deduct this tax before paying you the balance.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.
Things to be aware of
Be sure to check each year that the correct amount of income tax has been deducted from the pension payments you receive – particularly if you have other sources of income, like a part-time or full-time job (you can draw a pension if you’re still working), bank or building society interest or money earned from investments.
You can reclaim tax from HMRC if they’ve deducted more than you should have paid. Likewise, you might have to pay any tax that has been underpaid.
Also, while you have the option to delay receiving your pension, you may also be tempted to withdraw it all in one go. Be warned, though: this will trigger more tax than if you were to organise annual payments or invest your funds.
You should also be aware that you could become liable to pay higher rates of income tax if you take substantial amounts from your pension pot. You can also access free impartial pensions guidance from the Pension Wise website pensionwise.gov.uk or you can book an appointment over the telephone on 0800 138 3944.
What to consider when planning your financial future
Flexible pensions and tax-free pension withdrawal can be complex.
It would therefore be unwise to go it alone and make changes to your pension arrangements, as there could potentially be unforeseen and unintended consequences
Before drawing down, ask yourself: what’s the money for? Do you urgently need a lump sum for something unavoidable? Or are you just taking it as an indulgence?
The obvious choice is to avoid dipping into your pension fund until you actually need to. Do you have other sources of income to rely on? Think about how much income you need, and when you need it.
Another option – Self-Invested Pension Plans (SIPPs)
Self-Invested Pension Plans (SIPPs) offer a wider range of investment options than those available through most traditional pension plans. Investment is allowed in a number of assets and asset classes including equities and commercial property.
SIPPS are highly flexible but will not be suitable for everybody – especially people with limited experience of actively managing investments.
You can withdraw 25% of your SIPP fund tax-free. You might choose to do that as an upfront tax-free lump sum. Or you could have the first 25% of each
drawdown payment paid tax-free. Either way, you will pay tax on 75% of your fund when it is withdrawn
The investment growth within the fund is currently free from all UK Income and Capital Gains Taxes.
The value of a SIPP can fall as well as rise, so there is the risk that you may get back less than you invested.
Nevertheless, SIPPS are – for very good reason – an increasingly popular option among people planning their pension.
Understand your tax planning options
All in all, there are a number of different ways to approach your pension strategy, whether you’re already retired, about to retire or are some way off retirement yet. Take your time to understand your options – and get help and advice for what is a decision that will impact your retirement income for the rest of your life.
If you would like to discuss your pension options, please get in touch with us.
Many financial advice companies will offer what is known as an ‘off the shelf’ solution and although such options can be affordable, they are generic solutions that are not tailored to individual needs. At Sage Wealth Management Ltd, our services are fully bespoke to you. This means that our financial services are fully tailored to your needs.