Pensions taxation and the importance of planning ahead

Pensions taxation and the importance of planning ahead

Pensions as we have them today are deemed exempt, exempt, taxed – otherwise known as EET. This means that payments into a pension are tax-free because they get tax relief, the growth is tax-free, and only once income is taken in retirement will tax be paid – though of course 25 per cent of the fund can be taken tax-free at that point.

It all sounds very simple: taxed deferred is taxed saved, as they say. However, in the world of pensions, the existence of the EET system doesn’t actually mean that no tax will be paid until the point of retirement. It also doesn’t mean it is as simple as paying income tax on the amount taken as income. The reality is lot more complex than that, and all the charges that could be applicable should be considered. 

Annual allowance charge

The first thing to note about the annual allowance charge is that it is designed to reclaim from the individual any tax relief they have received on pension contributions or accruals over their annual allowance. This should mean that the individual won’t end up out of pocket, because they should have already received the tax relief from the government. 

In practice, because of the way different schemes work and the fact that some of the contributions will be made by an employer, it may feel like the result is negative rather than neutral. While these issues can be particularly complex in cases involving a defined benefit pension scheme, most of the time the result is still positive.

The annual allowance charge is a stand-alone tax charge so there is no way to avoid it. The charge has to be declared and/or paid using self-assessment; there is no simplified way of doing this for those that don’t usually complete a self-assessment tax return.

Such charges have increased for many over the past few years due to the introduction of the tapered annual allowance, which means annual allowances could reduce to as low as £10,000 for high earners – if their earnings including pension contributions and capitalised accrual are in excess of £210,000.

It is very difficult for those with variable income and bonuses that are paid late in the tax year to know what their earnings will be, making it hard to determine their tapered annual allowance. Couple this with a DB scheme where the amount of capitalised accrual is also determined by income at the end of the tax year, and an individual can be in an impossible situation when it comes to planning.

But this is where carry forward can be useful. The annual allowance unused in the previous three years can be set against the current year’s pension contributions and capitalised accrual. For some, this can mean no tax charge if it is an unusual year, but for others this flexibility will soon get used up, meaning annual allowance charges will be incurred each year.

The excess contribution is added to the earnings to determine the rate of tax applicable; if it spans two tax bands then the charge will be charged at the two different rates.