Tax breaks on pensions make them a great way to save!
Thanks to pension freedoms, many people dip into their life savings when they choose, from the age of 55.
If this is what you want to do, taking your pension as Income Drawdown as it’s known, then there are a number of things to consider if you are to make the most of your money.
This starts with knowing how your pension is taxed.
Here’s our guide through the basics for you:-
- You can normally take a quarter of your pension savings tax free!
Many people look forward to taking the tax-free money that pensions offer but aren’t sure how it works.
When you access your pension savings, a quarter – 25% – is normally paid to you tax-free.
When you take this is up to you, as long as you have a modern, flexible pension. You can take it all at once, as people used to do when they took out an annuity but you don’t have to.
Since pension freedoms were introduced, you can now take this tax free cash out in slices over a number of years if the pension scheme you are in lets you. Most now do.
This is known as phasing.
But just because you can, doesn’t mean you should take all – or any of it.
The longer your money stays inside your pension scheme, the more potential your funds have to grow in a tax-efficient way and the higher your tax-free cash could be. Of course, that’s not guaranteed and the value of your pension can go down as well as up and could be worth less than what’s been paid in.
And remember, if you do take tax-free cash, taking it out over a number of years could be a smart move as it could be much more tax efficient overall.
- How you take your money can make a real difference
Apart from wanting to make your money last, when and how you take your pension can make a big difference to how much tax you pay.
Taking your pension income little and often can make all the difference so that you don’t pay more tax than you need to.
- The benefit of little and often…
Whatever your plans for life after 55, whether that’s to work less, set up your own business or travel, taking out just what you need and leaving the rest until you need it could be a clever move for most people. Your funds will then remain invested in a tax free environment with the potential for continued growth.
Taking out more than you need and putting it in a bank account or low-interest savings account isn’t such a great idea; inflation will steadily eat into it.
- How tax works with your pension income
Most people will have a personal income tax allowance that means they don’t have to pay tax on the first £11,850 of their income, whether this income be salary or rental income or indeed, from the taxable part of pensions.
When you take money from your pension over and above your tax-free portion, it’s taxable just like any other income – such as the State Pension (when it kicks in).
So this income could use up some or all of your personal allowance.
Please note if your income exceeds £100,000 you may not get this allowance. If that’s you, talk it over with your adviser.
You pay 20%, 40% or 45% income tax, depending on which tax band your income falls into on any taxable pension income(excluding your tax-free cash) and the personal allowance you receive every year.
If you’re a Scottish taxpayer, your rates will be different.
Taking just enough to keep yourself in the lowest possible tax band will mean that you keep more of your money overall.
- Last but not least, passing it on
Recent changes have made pensions a great way to pass your money on, sometimes tax free to whoever you want to inherit it. And inheritance tax isn’t normally due on your pension savings, meaning wealth can be passed on down the generations.
I’ll cover the ins and outs of how that works in another blog!
The information is based on our understanding of taxation legislation and regulations in May 2018. The legislation and regulations can change. Your personal circumstances also have an impact on tax treatment.