The taxing decision of pension withdrawals
A reader recently emailed in with a question about his and his wife’s SIPP pension. They both contribute £2,880 each year into pensions and £720 of tax relief is added so £3,600 is invested into their funds.
The question surrounded the readers’ wife, who is a nontax payer now, and is likely to remain a nontax payer.
He wanted to know if his wife would pay tax on the pension when she withdrew the money.
The readers’ wife will not pay tax as long as her total taxable income (which includes the state pension) is less than the personal allowance, in 2019/20 it is £12,500
So if her pot was £76,000 she could take 25% or £19,000 from age 55 onwards tax-free. She would then have £57,000 remaining so she could take £12,500 each tax year for five-years and pay no tax on the pension.
If however, she took the remaining £57,000 as a single payment in one year, this would exceed the £12,500 of personal allowance and the excess would be taxed at either 20% or 40%.
Investing £2,880 annually into a pension is an excellent choice for most non-taxpayers, especially those with estates which will be subject to inheritance tax and with sufficient capital and income from other sources to not require the money for daily life.
That’s because a non-taxpayer receives tax relief on the contributions they make to the pension: for every £100 paid into the fund, HMRC will add a further £25. The £2,880 figure is the maximum annual pension allowance for a non-taxpayer, so with tax relief included the total paid into the fund is capped at £3,600 per year. (Taxpayers receive tax relief on contributions up to their annual income or £40,000, whichever is lower.)
Contributions, plus the added tax relief, are normally invested within the pension and grow without any income or capital gains tax. A significant additional benefit for taxable estates is that pension funds fall outside of the member’s estate, and are therefore not included when calculating inheritance tax.
But how can the same non-taxpayer make the most of their capital when it’s time to draw down?
Maximising tax benefits on withdrawal
A pension fund can be accessed at any age after 55, with no maximum age. The minimum age of 55 will increase to 57 from 2028, and will be linked to the State Pension age minus 10 years thereafter.
When pension funds become accessible, 25% can be taken without paying income tax; this is known as ‘tax-free cash’. Note that if this tax-free cash is not spent, it will form part of your estate for inheritance tax – so think about your plans carefully before you take it, it may be better left in the pension.
The remaining 75% of the pension fund can be taken in several ways, with the most common being either an annuity purchase or flexi-access drawdown – which effectively means the member can withdraw any amount they desire, up to taking the full pension fund in one lump sum payment.
A non-taxpayer can calculate how much they can withdraw without paying income tax by using their personal allowance, which is currently £12,500 in 2019/20. Assuming no other taxable income in the year, this amount can be drawn down annually without paying any income tax. If there is other taxable income, adjustments will need to be made as necessary to stay under this threshold.
By doing this, not only does the member benefit from the tax-free growth of their pension fund, but the full amount of tax relief that has been provided is ‘free money’.
This won’t work for everyone, since most people will pay income tax when they draw their pension as they surpass the personal allowance threshold, but it does work for non-taxpayers and those whose income tax rates are lower in retirement than pre-retirement. The income tax difference is the ‘free money’.
But do remember what I touched on earlier: although this is a great way to maximise your pension, if you don’t need the money and leave it in the pension wrapper, it will fall outside your estate on your death. If the pension member’s death occurs before age 75 it can pass tax-free to their nominated beneficiary; and if death occurs from age 75 onwards, the recipient pays income tax at the beneficiary’s income tax rates – which could still be within their personal allowance, since everyone in the UK (including minors) has a personal allowance of £12,500.
The pension reforms introduced in April 2015 have made pensions excellent retirement and estate planning vehicles, offering the flexibility for most people to maximise contributions to their funds and to delay taking benefits from them.