Tax on Pensions - Beware the Tax Trap

Traditionally if you had a pension pot, it could be used to buy an annuity, which would give you a guaranteed pension for the rest of your life.  However, from 6 April 2015, for anyone aged 55 or over with a defined contribution pension, it will be possible to access their pension funds in their entirety.

There will in theory be four options:

1. Take an annuity to secure a guaranteed income for life;
2. Take the whole lot at once with a quarter tax free and the rest taxable at your highest rate of income tax;
3. Move into flexi-access drawdown.  This will enable you to take your 25% tax free lump sum in one go, leave the rest invested and take an income from your fund when you need it.  Anything withdrawn above the 25% tax free lump sum will be taxed at your highest income tax rate;
4. If you don’t need your tax free lump sum in one go, choose an arrangement where every time you withdraw money from your pension 25% will be tax free and the balance will be taxed as income.

The purpose of this post is not to provide advice in respect of the best way to take your money.  Instead, it is to point out that tax on pensions is a significant issue which needs considering, as there will be tax consequences of receiving large one-off chunks of income.

For the 2015/16 tax year, the tax thresholds are as follows:

Personal allowance         to £10,600

20% tax band               £10,601 to £42,385

40% tax band               over £42,386

In addition, when your income exceeds £100,000, you start to lose your personal allowance (giving you a marginal rate of tax of 60%) and when your income exceeds £150,000, you pay the additional tax rate of 45%.

Scenario 1

Imagine you are aged 60 and have a pension pot of £100,000 which you would like to take in full.  You also have employment income of £20,000.

If you took the second option (take the whole lot at once), then you would receive £25,000 tax free.  The balance would be taxed at 20% (£42,385 - £20,000) and 40% (£75,000 - £22,385), giving a total tax bill of £25,523.  Ouch!

Scenario 2

Now imagine the exactly the same figures and facts as scenario 1 (using the same tax rates for comparability), but instead of the whole £100,000 being taken at once, it will be split evenly over 2 tax years, 2015/16 and 2016/17.  This will be done using the fourth option, so that £50,000 will be taken in each tax year and 25% will be tax free.

In this scenario, the total tax bill will drop to £21,046, a tax saving of £4,477.

However, in both scenarios, it is the amount of pension which is being taken which pushes the taxpayer into higher rate tax, paying tax at 40%.  The tax bill could be cut further by spreading the withdrawals over several tax years.  40% tax could be completely avoided by restricting the maximum pension taken each year to £29,846.

Conversely, it can be seen that the tax situation could be a lot worse for individuals who have larger pension pots, if they don’t consider the tax impact of taking large amounts.

Therefore, as tempting as it may be to take the whole balance of your pension pot in one fell swoop, it can have a significant effect on the amount of tax you pay.