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 £35,000 a year in the current tax year, you'll be on the 'basic rate' of income tax - 20%. This means that for 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 £35,000, you pay 40% income tax. If you're earning more than £150,000, you'll pay a rate of 50%.
If you're a higher or additional-rate taxpayer (40% or 50%) 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 sacrifice 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 is deducted.
You can find out more about tax relief on pensions at www.direct.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 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 £50,000 This means that any payments over this limit could be taxed from 40% to 50%. But if the total payments in a year are less than £50,000, you'll be able to carry forward the unused allowance for up to three tax years.
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 £1.8m and is expected to reduce to £1.5m in the 2012/13 tax year.
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.
You can find out more about pension allowances at www.hmrc.gov.uk.
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:
- 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'r expected to live.
- 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 saving to your pension plan, along with the exchanged amount.
However, salary exchange schemes may not be right for everyone.
Mortgage lenders usually calculate the maximum borrowing level as a multiple of salary. As your salary is lower under salary exchange, your mortgage borrowing may be affected.
Important legal and regulator information
References to legislation and taxation are based on current rules. Legislation and taxation may change in the future. The value of investments, and any income from them, can fall as well as rise and you could get back less than you invest. All figures relate to the 2011-2012 tax year, unless otherwise stated.
