Tax and pensions are two of the most complex factors for any individual planning to retire, access their lifetime savings, move abroad to another country, or make informed, intelligent decisions about the best way to manage their retirement assets.
One of the common misconceptions is that income tax is only payable against regular pension benefits since pension freedoms mean that most pension lump sum drawdowns, up to 25%, are tax-free. However, this may not be the case, where tax allowances, reliefs and exemptions are not universal, and there are multiple caveats to be aware of.
For example, although the standard 25% tax-free lump sum drawdown assumption is correct, from the 2023/24 tax year, that only applies to lump sums up to £268,250, and anything above that value will potentially be taxable.
Pension Payments and Transactions That Attract UK Income Tax Obligations
There are multiple aspects of pension contributions, drawdowns and transactions that can give rise to a tax liability, although this can depend on the type of pension scheme you have, your age, and other circumstances such as your country of residence and taxpayer jurisdiction.
Examples include:
- Making contributions to your pension fund.
- Transferring a fund to a different scheme or investment structure.
- Drawing a lump sum from your pension wealth.
- Arranging periodic pension benefit payments.
- Leaving pension assets to an inheritor.
Until April 2023, the Lifetime Allowance (LTA) would also have added an event to that list, whereby a tax charge would arise if any crystallisation event were to occur and your total pension wealth was over the £1.073 million cap.
For the time being, the LTA has been removed. However, there is a certain amount of speculation about whether this may be reintroduced in the future, particularly if a change in government occurs at the next general election. More information is available through our 2023 Lifetime Allowance Guide.
The takeaway is that UK income tax doesn’t solely apply to the benefits you extract from your pension but can be a significant financial aspect of every part of your pension and retirement planning.
Different Pension Tax Relief Systems for Workplace Funds
Pension tax reliefs can apply differently for employees making contributions to their workplace fund, depending on how the provider or employer manages the scheme. There are two potential ways to benefit from tax relief:
- The ‘gross tax’ basis means your contributions are deducted from your pay before taxation, providing full tax relief by excluding pension deposits from income tax.
- The ‘net tax’ basis involves contributing pension funds after taxation, where the pension fund then claims the tax relief on your behalf, usually adding 20% (based on the basic rate) to your pension fund.
While both options seem to have the same financial outcome, higher-rate taxpayers may need to claim tax relief for the balance, assuming the tax relief repaid on a net tax basis pension fund remains at 20%, to avoid unnecessarily paying further income tax of up to 25%.
This becomes more complicated for pension savers with an annual income above the annual allowance – the cap on the amount you can deposit into a pension fund without an income tax obligation. Tax relief is applied on all UK pension contributions up to 100% of your yearly earnings, but this changes for higher earners with an income of £60,000 or above.
Income Taxes Payable on Pension Contributions
Contributions made to UK pension funds are not taxable up to the annual allowance, but taxpayers with an income of over £200,000 or an adjusted income (including figures such as employer pension contributions) of over £260,000.
In these instances, and for pension savers who have previously used flexible access to draw on their pension fund, the annual allowance is reduced on a tapered system. The allowance is reduced by £1 for each £2 your income exceeds the threshold, meaning any pension contributions over and above are exposed to income tax.
However, a minimum allowance of £10,000 is available to all taxpayers for the current tax year.
Paying Income Tax on Pension Withdrawals
All UK taxpayers receive an annual personal allowance, set at £12,570 for 2023-24, although this can change for those with incomes above £100,000 or claiming allowances such as the Marriage Allowance.
In effect, that means any pension income received, whether from the State Pension, a private scheme or a workplace fund, is subject to income tax at your marginal tax rate, based on the current tax brackets of:
- 20% tax on income from £12,571 to £50,270.
- 40% tax on income from £50,271 to £125,140.
- 45% tax on income of over £125,140.
The government has confirmed that it intends to keep these bands frozen for the next three tax years until 2027/28. We have previously published an article exploring How UK Tax Band Freezes Impact Expat Wealth and, indeed, exposure for any taxpayer with a British-based pension fund or income.
Additionally, lump sum withdrawals may be taxable, depending on protections built into your pension product and other features that safeguard your right to access a larger proportion of your fund without a tax penalty. Otherwise, the lump sum tax-free limit remains at 25% of the previous LTA.
Pension Tax Liabilities for Varied Funds
Added to these many considerations, much may depend on the type of fund you have – that could be one of the following or several:
- The UK State Pension or a workplace defined benefit or defined contribution scheme.
- An overseas pension fund such as a Recognised Overseas Pension Scheme (ROPS).
- A private pension scheme like a Self-Invested Personal Pension (SIPP).
- An older pension fund pre-dating the 2015 Pension Freedoms Act.
In every case, it is essential to understand what tax liabilities will arise and when and on which transactions, contributions or drawdowns to ensure your retirement savings are not unnecessarily eroded.
For further advice and a personalised analysis of your pension finances, retirement wealth, and likely future tax obligations, please contact Chase Buchanan Wealth Management to arrange a convenient time to talk.
*Information correct as at June 2023