Everyone has an opinion on taxes. Just a quick Google search as I was researching this article turned up hundreds of pithy comments and quotations.

The best known is probably Benjamin Franklin’s “In this world, nothing is certain except death and taxes."

I’m sure you have your favourites, and your own opinions about taxation. From a financial planning point of view, my belief is that it’s important that you’re aware of the relevant taxes and their impact.

It’s also equally important for you to understand the steps you can take to mitigate them, and to make as full use as possible of valuable tax incentives.

Here are seven key points about pensions and taxation.

1. Pension contributions are heavily incentivised

To encourage you to save for your retirement, the generous incentives the government give on pension contributions make them a highly tax-efficient savings vehicle.

Basic-rate tax relief is automatically added to all personal contributions.

For example:

•  Jane pays £200 monthly into a private pension arrangement.
•  The government automatically add a further £50 in basic-rate tax relief.
• As a result, a total of £250 gets credited to Jane’s pension each month.

So, on day one, the value of Jane’s investment into her pension has grown by 25%. That alone makes pensions an attractive option.

Note that if you are only paying Income Tax at 19% in Scotland, your pension provider will claim tax relief for you at a rate of 20%. You do not need to pay the difference.

2. You get tax relief on all personal contributions, even if you’re not earning

One little-known tax advantage of pensions is that you’ll automatically get basic-rate tax relief on contributions, even if you aren’t working, or not earning enough to pay tax.

You can pay £2,880 into a pension each year and tax relief will top this up to a maximum of £3,600. This can be a useful benefit for a spouse or partner who isn’t working, or even a child.

Also remember that it may be possible “carry forward” unused pension contributions from the previous three tax years.

3. You can claim higher rates of tax relief through your self-assessment tax return

As well as having basic-rate tax relief added to your contributions, you can also claim higher and additional-rate tax relief on contributions. You do this either through your self-assessment tax return or by contacting HMRC direct.

Note that higher rates of tax relief won’t be added to your pension. Any relief you are entitled to will be credited as an adjustment to your tax code or paid by HMRC as a tax rebate paid directly to you.

 If you are a member of your employer pension scheme and your payments are made from your salary before you pay tax or under salary sacrifice, then you effectively get the tax relief automatically (by reduced PAYE tax).

If your employer pension scheme has basic rate relief added after your payments have been made, then you may still need to reclaim any higher rate tax relief through your self-assessment.

4. There are restrictions on the amount of tax relief you can receive

Clearly there are limits when it comes to government generosity and pension tax relief.

The maximum annual amount eligible for tax relief is, in the 2021/22 tax year, either 100% of your earnings or £40,000 gross – whichever is lower.

You can pay more than £40,000, but if you do exceed that, tax relief will be clawed back, which means it becomes tax-inefficient.

The other key point to note is that once you start taking money from your pension (apart from tax-free cash) your maximum tax-efficient contribution limit reduces to £4,000.

5. You need to be aware of the Lifetime Allowance

The other key issue to bear in mind when it comes to pension contributions is the Lifetime Allowance (LTA).

The LTA is the overall limit of tax-efficient pension funds you can accrue during your lifetime before a tax charge applies.

The standard Lifetime Allowance is £1,073,100 (2021/22 tax year).

The tax charge for exceeding this can be up to 55%, so careful planning is advisable. I would recommend that you get professional advice from an expert if you think you may exceed this figure.

6. It’s important to plan how you take income in retirement

On the face of it, the tax situation when you start drawing money from your pension fund – either regular income or lump sums – is simple. 25% of your fund can be taken tax-free, and you’ll pay tax on the remainder.

As with most taxation issues, however, it’s not necessarily that straightforward. It’s therefore important to plan ahead and have a strategy in place to mitigate the amount of tax you pay.

Everyone’s financial situation will be different so any plan will be bespoke and tailored to your individual circumstances.

Some of the potential options to minimise tax could include:

• Taking tax-free cash on a regular basis rather than as a lump sum. This will mean that only 75% of each withdrawal will be taxable.
• Making the most of both your annual Personal Allowance, and that of your spouse or partner. The current Personal Allowance is £12,570 (2021/22 tax year), which means that you can take a tax-free income of more than £25,000 between you.
• Maximising other advantageous tax opportunities such as the Capital Gains Tax allowance – £12,300 in 2021/22 tax year – and being able to take money out of your ISA tax-free.

7. Passing your pension fund to future generations

As well as planning your retirement income carefully to keep the amount of tax you pay to a minimum, it’s also worth considering the tax position relating to your pension fund on your death.

The rules around this can be complicated, depending on whether you’ve started taking regular income from your fund. But if you die before you reach 75, whoever inherits your fund will typically not pay any tax on it.

This is clearly a very advantageous tax benefit, to the extent that there is regular speculation that it could be withdrawn, or adjusted, by the government in the future.

It’s worth ensuring you get specialist advice on this, and the other points raised in this article.

Get in touch

To find out more about pensions, taxation, and planning for your retirement, please get in touch.

Email me at graeme@macfp.co.uk or call me on 01349 832849.

Please note

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.