Pension planning can be complex, and in an ideal world, everybody would like to access their retirement savings without paying higher taxes than necessary, with options to make pension lump sum withdrawals to match their requirements.
Specific rules and liabilities differ, depending on the type of pension pot you have, the amount you wish to withdraw as a lump sum, and whether you are at state pension age – but understanding the likely tax bill associated with drawing down funds from your pension scheme is essential.
Chase Buchanan has summarised some key information you need to know about paying tax on pension lump sum values, the maximum tax-free cash you can usually access and why your retirement savings structure will affect your options.
Changes to British Pension Tax Liabilities
As of the Spring Budget 2023, retirement savers are likely to welcome the news that the Lifetime Allowance (LTA), previously capped at £1.073 million, has been abolished with immediate effect. This tax rate reform is expected to be formalised during the 2024-25 tax year, with a planned Finance Bill to lift the previous tax obligation levied on all pensions above the cap.
Further, the maximum a taxpayer with UK-based pensions can draw as a tax-free lump sum towards their retirement income is now capped at £268,275, frozen at 25% of the now removed LTA.
However, the terms within your pension fund may protect your right to a higher lump sum, typically detailed as a pension commencement lump sum, or PCLS.
A lump sum payment, which would, under the previous system, attract a 55% taxable charge for funds over the LTA, remains taxable but at your marginal tax rate, including death benefits and ill-health lump sum drawdowns.
These intricacies mean that even if the tax charge associated with a lump sum withdrawal looks straightforward, it is sensible to consult a professional, independent financial adviser before making any decisions that may impact your long-term financial stability and taxable pension wealth.
UK Taxes on a Domestic Pension Fund Lump Sum
Generally, a pension fund held within the UK will be subject to the above calculations and rules. You shouldn’t expect to be subject to a large tax liability or any impact on your other income if you meet the lump sum drawdown criteria.
Although clauses, benefits and rights may vary between pension schemes, the standard rules are that:
- Tax-free drawdowns are permitted up to 25% of the pension value.
- Individuals making a pension drawdown do not attract a tax charge if they are 55 or above.
- The 75% pension fund balance is taxable at the person’s marginal tax rate.
- Lump sum tax-free drawdowns do not affect the personal allowance.
Note that these conditions are not universal – for example, smaller pension funds worth up to £10,000 may allow a 100% drawdown, called a small pension pot drawdown. Although only 25% is tax-free, fund holders can withdraw the full balance as a lump sum at their discretion.
A similar rule applies to defined benefit pension funds, where 25% of a lump sum withdrawal is tax-free, but you may be permitted to close the account and withdraw the total amount if it is worth £30,000 or less; you will pay tax on the 75% balance at your marginal rate.
Pension savers with several private funds may not be allowed to close out one smaller-value account if their overall pension fund savings exceed this threshold.
There are some exceptions, where retirees can withdraw the entirety of the pension fund tax-free, depending on the provider’s rules, usually if they are seriously unwell or have a limited life expectancy. In this scenario, some funds will reserve the right to retain 50% of the value.
Taxes on ROPS Pension Lump Sum Drawdowns
UK pension funds are one of many options. Expats may transfer their pension assets, reinvest in different account structures, or select a compliant scheme included in the HM Revenue and Customs Recognised Overseas Pension Scheme (ROPS) list.
This approved list can and does change regularly, so you should research your options carefully and ensure the terms and conditions of any prospective overseas scheme are compatible with your expectations – and the fund remains approved.
Transferring British pension savings to a scheme no longer considered a ROPS can attract steep penalties of 55%. It is also possible for the fund administrator to levy a charge to action the transfer request, and an international transfer can trigger a 25% Overseas Transfer Charge, so this transaction is not without cost.
The benefit from a lump sum drawdown perspective is that a ROPS fund will allow taxpayers to draw down a higher tax-free 30% single lump sum rather than 25% if they have lived overseas for at least five years and are 55 or above.
Caution is advised if your ROPS fund offers a 100% lump sum drawdown. This feature is incompatible with HMRC expectations and can result in a clawback of 55% of the pension value: the equivalent transfer penalty payable when shifting a UK fund to an unapproved overseas scheme.
Paying Tax on a Lump Sum From a SIPPs Pension
A further option is a Self-Invested Personal Pension, or SIPP, which offers many of the benefits of ROPs, but with no requirement for HMRC approval, and the major advantage of forgoing the potential exposure to the 25% Overseas Transfer Charge since the fund remains in the UK.
This type of private pension scheme is self-invested, which means you have discretion over the assets you invest your retirement savings in, including shares, open-ended investment companies and overseas stocks.
Expats often opt for SIPPs to access the investment freedom and customisation options while retaining tax-free 25% lump sum access without needing to pay more tax.
Because a SIPP is a UK-domiciled pension pot, the tax-free lump sum remains 25%, but, as with a ROPS fund, taxpayers must review their tax residency position to ensure they don’t inadvertently attract a tax liability in an overseas country of residence, even if their drawdown is exempt from tax in Britain.
Whichever option you select, any lump sum drawdown over and above the tax-free threshold will normally be taxable in whichever country you are considered a tax resident, based on your effective income tax rate – which may be a factor if you fall into a higher tax band based on your other income.
Other Pension Tax Considerations
While you will find a lump sum tax efficient in many cases, provided you remain within the restrictions outlined above, it may also be important to clarify which pension income is categorised as a lump sum.
As with many aspects of pension income planning, this can become complex because:
- A pension pot with a built-in drawdown feature may automatically move 25% to the drawdown facility, but providers may also introduce capped drawdowns and flexible access drawdowns.
- Older pension schemes, predating April 2015, usually have a capped limit the holder can draw from their pension before they pay tax, based both on the 25% tax-free lump sum and the product itself.
- Flexible access usually means the holder can draw the available lump sum and use the balance to withdraw regular payments or draw further ad hoc lump sums as and when they wish to.
Moving a fixed amount to drawdown status may be possible, but no further tax-free lump sum payments are available after this value has been drawn. However, much depends on the scheme and the withdrawal options presented.
The UK Pension Contribution Annual Allowance
Finally, pension taxation applies to the contributions made to a fund, as well as withdrawals made either through lump sum payments or regular pension benefits.
In April 2023, when the LTA was removed, the Chancellor also announced changes to the annual allowance, or money purchase annual allowance. This personal allowance caps the amount each individual can deposit into a pension pot without tax obligations arising.
The general limit is now £60,000, increased from £40,000, but those with higher rate incomes may still be subject to taxation if they exceed a tapered allowance calculated against their total annual income.
Taxpayers with threshold earnings above £200,000 and an adjusted income of £240,000 or more receive a tapered allowance.
While the calculation is complex, the threshold income includes employment, business and interest earnings, less pension contributions. The adjusted income figure incorporates non-cash revenue, such as employer’s pension contributions, to arrive at a total basis.
If you meet the thresholds, with the adjusted income cap increased from £240,000 to £260,000 from the 2023/24 tax year, your personal allowance, or the total you can deposit into your pension pot without a taxable charge, reduces by £1 for each £2 above the adjusted income cap.
Professional Advice on Pension Taxation and Lump Sum Drawdowns
As we’ve demonstrated, tax on pension lump sum withdrawals can be far more complicated than it may appear. Chase Buchanan recommends that every expat planning their retirement income works with a wealth management adviser with an up-to-date knowledge of the tax rules in their country of residence before making any decisions.
While we have outlined here many of the relevant factors, there are potentially other considerations related to your tax position, pension income and overall earnings, as well as whether you are at state pension age.
If you are considering the right international pension transfer or structure for your pension fund, please download our complimentary Guide to SIPPs v ROPS, which explores the pros and cons of each option.
Alternatively, you are welcome to contact your local Chase Buchanan Wealth Management branch for tailored advice from our global team.
*Information correct as at March 2023