Pensions and tax

To encourage people to save for retirement, the government offers tax breaks on money saved into pension schemes.

Tax on pensions

If you earn up to £41,865 a year in the current tax year, you'll be on the 'basic rate' of income tax - 20%. This means that for some pensions every £80 you pay into your pension, you end up with £100 in your pension pot as your pension provider claims tax back from the government at 20%.

There are two tax rates for higher-rate taxpayers. If you're earning more than £41,865, you pay 40% income tax. If you're earning more than £150,000, you'll pay a rate of 45%.

If you're a higher or additional-rate taxpayer (40% or 45%) you need to claim back your additional tax relief from HMRC. This is because only basic-rate tax relief of 20% is added on to pensions automatically for certain types of pensions.

Remember, if you pay into your pension pot using a salary exchange arrangement, there is no tax relief to reclaim. This is because your employer pays the money you've exchanged from your salary into your pension pot before any tax is deducted.

You can find out more about tax relief on pensions at www.gov.uk.

Tax allowances

There is a limit on the amount of money you can save into your pension before it's taxed. This limit is called the annual allowance.

You can put all of your earnings into a pension plan and receive income tax relief up to the lower of 100% of your earnings and the annual allowance. You can also pay into a company personal scheme and a personal pension at the same time, without affecting your tax relief.

Annual allowance

Currently this allowance is capped at £40,000. This means that any payments over this limit could be taxed from 20% to 45%. But if the total payments in a year are less than £40,000 you’ll be able to carry forward the unused allowance for up to three tax years. £50,000 will continue to apply for carry forward from tax years 2011-12, 2012-13 and 2013-14.

Lifetime allowance

There's also a limit on the size of pension fund you can accumulate by the time you retire. This is known as a lifetime allowance. It's currently £1.25m for 2014-15.

If you have a pension fund larger than this the excess can be subject to additional taxes. The rules are quite complicated so it's worth taking professional advice if you have a large pension fund.

Find out more about pension allowances.

Drawing an income from your pension fund

When you retire you can usually take up to 25% of your pension fund as a tax-free lump sum. The rest of your income, however, will be subject to income tax.

You can use your remaining fund to:

  1. Buy an annuity (a regular income payable for life) from a life insurance company. This can be with a different company from the one you have your pension plan with. The income from your annuity will depend on various factors, the key one being how long you're expected to live.
  2. Draw a taxable income directly from your pension fund.

Boost your pension through salary exchange

One way to boost your pension pot is through something called a 'salary exchange' scheme.

How salary exchange works

You exchange part of your salary. The amount you exchange is paid to your pension plan directly by your employer, rather than being paid to you.

Because your salary is lower, you and your employer pay less National Insurance Contributions (NIC). As part of the salary exchange deal, your employer may pay all or part of the money it saves in NIC to your pension plan, along with the exchanged amount.

However, salary exchange schemes may not be right for everyone.

One example of this is:

Mortgage lenders may calculate the maximum borrowing level as a multiple of salary. As your salary is lower under salary exchange, the maximum mortgage you can borrow may be affected.

Important legal and regulator information

Laws and tax rules may change in the future. The information here is based on our understanding in April 2014. Your personal circumstances also have an impact on tax treatment. All figures relate to the 2014-15 tax year, unless otherwise stated.

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