Pension tax basics
When it comes to tax, pensions work on what is called an exempt-exempt-taxed basis. In this post, we’ll be covering what this means for defined contributions schemes (also known as pension pots)?
When you pay into a pension scheme, these contributions are tax-deductible up to a certain limit. This means you do not pay tax on any of your payments going into the scheme. That’s good! And when your pots build up in the scheme, you also pay no tax on the growth you get within the scheme. Even better!
However, when you do decide to withdraw money from your pension, you will get taxed on it as if it were a salary. Although that may not seem so great, one upside is that you can take 25% of any pot you build up without paying any tax.
Those are the basics; but how can you claim back tax on pension contributions or income if you’ve overpaid? And how can you reduce the overall tax you pay when taking an income from your pension pots? Let’s see:
Pension contributions
There are three ways that your pension contributions may be treated by your provider or workplace scheme. It is really important for you to understand how your scheme works, as this will determine what you need to do if you ever need to claim any tax back.
- Salary sacrifice: this means you give up a percentage of your salary in return for extra pension contributions from your employer. Tax-wise, this is the most efficient option. Not only will you not need to worry about claiming it back, but you’ll also get savings on National Insurance contributions.
- Net Pay: once again, your employer will deduct your pension contribution before you pay tax. You won’t get the reduction in National Insurance contributions, but you won’t need to worry about reclaiming any tax back.
- Relief at source: this is where you may need to think about reclaiming tax. In this case, the pension contribution is deducted after your tax bill is calculated. The government will pay you back part of the tax you paid automatically (at the taxpayer basic rate). But if you pay 40% or 45% as a high earner you’ll need to submit a tax return and claim the rest (another 20-25%) back.
The last option is more of hassle, although it is actually better for non-taxpayers who can still get the 20% from the government added to their contributions even when they don’t pay tax.
If you are a 40% or 45% taxpayer and pay via relief at source, you need to fill in a self-assessment tax return before the 31st January after each tax year to claim this money back. For the tax year 2019/20, you’ll need to do this before 31 January 2021, or it’s gone forever!
We recently partnered with TaxScouts to help our users claim this tax back. They offer a tax return service for £119 all in. They do your entire tax return including anything related to pensions. By using our Guiide link, you’ll get 5% of your self-assessment!
They also have a great Private Pension Tax Relief tool that shows you how much you may be entitled to claim back.
Pension Income
Claiming tax back on your pension income is a little more complex, so we’ll show you practical steps you need to know to claim back any overpaid tax.
Whether you take your pots as a flexible income or receive guaranteed income for life (annuity), you can take 25% tax-free from the government. You can choose to do this by taking the 25% immediately as a lump sum, or 25% of each payment tax free.
Once you have taken your 25% tax-free, you will pay tax on any income after that that is above the allowance limit, currently at £12,500.
Depending on how you take your income there are a few practical issues which may end up with you overpaying tax. If you’d rather not wait until next year’s tax return to claim tax back, you can choose to fill in one of the following HMRC forms to reclaim tax overpaid:
- Form P53Z: Complete this form if you have taken your full pension pot amount in one go, but also have some other taxable income.
- Form P50Z: Complete this form if you have taken your full pension pot amount in one go and have no other taxable income.
- Form P55: Complete this form if you have some of your pension pot left and are not working or claiming state benefits.
If you have some of your pot left and you are working, you should pay the correct tax automatically via your other taxable income.
As you can see, it’s not very straightforward. There is a large risk of overpaying tax and not claiming it back at the right time with the correct form. If this is the case, the last chance to claim this tax back will be via a self-assessment tax return. That’s where using a service like TaxScouts comes in very handy: they will complete the tax return and reclaim any overpaid tax on pension income for you.
How to pay less tax in retirement
All of the plans we build our users at Guiide are made as tax-efficient as possible. We do this by combining taxable and non-taxable income in a way that reduces the expected tax payable over the whole retirement plan.
Sometimes, we are able to create the plan the user wants with no tax payable at all. We do this all for free in every plan built!
There are additional tax issues to consider for some users who make large pension contributions (above £40,000 per year), or who have with large pension pots of around £1m. In these cases, we would strongly recommend seeking expert financial advice given the amounts involved.
