17th May 2018 at 12:02pm
Tax breaks on pension saving, being able to access your pension pot from the age of 55, and the ability to leave a tax-efficient legacy, all make pensions 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 it as income drawdown as it’s known, there are things to consider to make the most of your money. It 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.
“There are myths around tax-free cash we’d like to bust,” explains David Downie, our technical pension expert here at Standard Life.
When you access your pension savings, a quarter – 25% – is normally paid 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, you can take this money in slices over a number of years if the pension you have lets you. This is known as phasing.
Just because you can, doesn’t mean you need to take all – or any of it. The longer your money stays inside your pension, 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 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 money 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 – and you keep your funds invested with the potential for growth.
Taking out more than you need and putting it in a bank account or low-interest savings account, for example, means you lose that, and inflation could steadily eat into it.
Tax-free cash is something many people think of first when taking their pension savings, so we’ve written more around this in taking tax-free cash from your pension.
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, such as salary or rental income.
When you take money from your pension over what you’re taking tax-free, it’s taxable just like any other income – as is the State Pension, when it kicks in. So you can use your personal allowance against it. People with a high income over £100,000 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 anything above your tax-free cash and the personal allowance you get every year. If you’re a Scottish taxpayer, your rates will be different and you can read more about that on www.gov.scot.
Taking just enough to keep in the lowest tax band you can and 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.
Want to read more?
We recommend talking tax through with your adviser so that you make the most of your money. If you don’t have one, you can find one at unbiased.co.uk.
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.
This article should not be regarded as financial advice. The right approach for you will depend on your individual circumstances.