9 pension tax tips

As the new tax year approaches, so does new allowances for pensions. It can feel like longer-term financial goals are unimportant in the face of a cost of living squeeze on household finances. But to have any chance of decent retirement, we must keep saving and investing. What’s more, the government lavish us with tax breaks and matched contributions to help our journey.    

The new tax year will also bring some changes. For wealthy savers at risk of breaching the lifetime allowance, this will be abolished. It will remove a significant penalty on strong investment performance – a sizeable disincentive to save. The annual contribution allowance is also being increased by 50% too. 

That said, pension savers need to avoid some pitfalls too. We caught up with AJ Bell’s head of retirement policy, Tom Selby, to get his top pension tax tips as the new tax year dawns. 

Five ways pensions can boost your retirement

  1. Upfront savings boost Part 1: Pension tax relief

“Pensions benefit from upfront tax relief, providing an immediate boost to the value of your fund. This is granted automatically at 20% of the amount going into your pension (which is the equivalent of a 25% boost to your contribution), while higher-rate taxpayers can claim back an extra 20% and additional rate taxpayers 25%.

“So, if you pay £80 into a SIPP, that will be topped up to £100 regardless of how much income tax you pay. A higher-rate taxpayer could then claim back £20, while an additional-rate taxpayer could claim £25. In effect, getting £100 in a pension can cost as little as £55.

“Schemes which take pension contributions from your pre-tax pay should pay your tax relief automatically provided you earn more than £12,570.”

  1. Upfront savings boost Part 2: Your FREE 100% savings boost!

“If you’re a member of a workplace pension scheme you’re also entitled to an employer contribution which, together with your tax relief from the government, should give you an immediate 100% bonus on the money you save for retirement.

“Furthermore, pensions allow you to access 25% of your fund tax-free from age 55, with the rest taxed in the same way as income. The age at which you can first access your pension is due to rise to 57 in 2028.

“The combination of upfront tax relief, tax-free investment growth and 25% tax-free cash from age 55 is extremely attractive for those who can contribute to a pension, while for most people staying in a workplace pension remains a no-brainer.

“Anyone with spare cash should consider making the most of their available pension allowances before the tax year ends on 5 April.”

  1. Carry forward to super-charge your annual allowance

“UK pension savers are entitled to an overall ‘annual allowance’ of contributions, covering employee contributions, employer contributions and tax relief. Pensions ‘carry forward’ rules allow you to use unused annual allowances from up to the three prior tax years in the current tax year, provided you were a member of a pension scheme in the tax year you are carrying forward from and your personal contributions don’t exceed 100% of your annual earnings.

“Following Chancellor Jeremy Hunt’s decision to hike the annual allowance from £40,000 to £60,000, in theory it means someone could pay in as much as £180,000 to their pension in the 2023/24 tax year without being hit with an annual allowance tax charge (their £60,000 annual allowance from 2023/24 plus 3 x £40,000 annual allowances from 2020/21, 2021/22 and 2022/23).

“Carry forward can be particularly useful for business owners or anyone who is trying to make up for lost time saving for retirement.”

  1. Pay profits into a pension and slash your tax bill

“If you’re self-employed then paying your profits into a pension is a great way to lower your tax bill. Take the example of a higher-rate taxpayer who owns a company and turns a profit of £20,000 in the 2022/23 tax year.

“If they are able to pay the entire £20,000 profit from the company directly into a pension as an employer contribution, the company shouldn’t have to pay any tax or employer National Insurance on the contribution. The money will be able to grow tax-free, with tax only coming into play when you come to make a withdrawal from age 55.

“In comparison, if they were to take the profit as salary (assuming the entire £20,000 remains in the higher-rate tax band), they will have to pay at least £400 in employee National Insurance and, as they are a 40% taxpayer, £8,000 in income tax. In addition, the business will have to pay employer National Insurance at 13.8% (£2,760)*.

“And if they decided to take the £20,000 profit as a dividend, corporation tax will first be levied at 19%, reducing the payment to £16,200. They would then pay a tax of 33.75% on the dividend above the dividend allowance of £2,000 (this is set to be reduced to £1,000 from 6 April), meaning they would end up receiving £11,408 after tax.”

*Calculations assume the NI rates that applied from 6 November 2022 onwards were levied on the entire salary. From 6 April 2022 to 5 November 2022, NI rates included an extra 1.25% charge.

  1. Using pensions to reduce inheritance tax bill

“While for most people the main purpose of a pension is to provide an income through retirement, reforms introduced in April 2015 mean pensions are now extremely tax-efficient on death. In fact, it often makes sense from a purely inheritance tax (IHT) perspective to spend other savings first, leaving your pension to last.

“Pensions are usually free from IHT on death and can be passed on entirely tax-free if you die before age 75. If you die after age 75 then any pensions bequeathed to loved ones will be taxed in the same way as income when they come to make a withdrawal.

“If they then die before age 75 then the funds can be passed on to their beneficiaries tax-free. As such, pensions now provide a way of passing money down the generations, with the taxman potentially not seeing a penny of it.

“From 6 April, the lifetime allowance tax charge will be abolished, making the pensions system much simpler and reducing the potential for a death tax bill for those with larger pension pots.”

Four bear traps to avoid

  1. If you’re at risk of being hit with a lifetime allowance tax charge, wait until 6 April to ‘crystallise’ your pension if possible

“Jeremy Hunt’s decision to remove the lifetime allowance tax charge from 6 April means it is vital anyone at risk of being hit with a charge before then holds off ‘crystallising’ their pensions if possible.

“When someone crystallises their pension, they trigger a lifetime allowance ‘test’. If this happens before 6 April and you are over your lifetime allowance, this will result in a lifetime allowance tax charge being levied on the excess.

“The term ‘crystallise’ includes taking your tax-free cash, entering drawdown, buying an annuity and accessing an ad-hoc lump sum direct from your pot. 

“Take, for example, someone who has used up all their lifetime allowance and wants to take an additional £10,000 from their pot as a lump sum. If they did that before 6 April, they would pay a £5,500 lifetime allowance tax charge. If they did it from 6 April onwards, however, there would only be income tax to pay on the lump sum.

“In addition, if you have one of the forms of lifetime allowance ‘protection’ introduced since 2006, these will be honoured under the new reforms. This means if, for example, you have a tax-free cash entitlement higher than £268,275, you will be able to keep it – so it’s important not to breach the terms of that protection before 6 April if possible.

“What’s more, you will be able to top-up contributions from 6 April 2023 without losing any protected tax-free cash entitlement you have.”

  1. Watch out for the ‘money purchase annual allowance’

“Hundreds of thousands of savers have flexibly accessed their retirement pot each year since the pension freedoms launched in April 2015. And with the high cost of living set to continue to be an issue for people throughout 2023, it is likely more over 55s will need to turn to their pension to plug a short-term income gap.

“It’s important to understand the consequences of flexibly accessing taxable income from your retirement pot. Most obviously, the earlier you access your pension, the longer it will need to last for in retirement. This means you will either have to adjust your lifestyle expectations accordingly or boost your contributions when you can afford to.

“However, anyone who makes a flexible withdrawal from their retirement pot triggers the ‘money purchase annual allowance’ (MPAA), permanently reducing their annual allowance and removing the ability to ‘carry forward’ unused allowances from the three prior tax years. While today that MPAA reduction is from £40,000 to £4,000, from 6 April the MPAA will increase to £10,000, at the same time as the overall annual allowance increases to £60,000.

“This welcome move will give hundreds of thousands of savers who have accessed their pension extra flexibility to rebuild their pensions over time. Nonetheless, it is still a substantial reduction in pension saving incentives – particularly with the annual allowance rising to £60,000 – and means accessing your retirement pot is a decision you shouldn’t take lightly.

“If you want to access your pension but are concerned about triggering the MPAA, consider just taking your tax-free cash or a portion of your tax-free cash, particularly where you are planning a one-off purchase rather than withdrawing a regular income.

“It is also possible to access up to three separate personal pension pots worth £10,000 or less without triggering the MPAA, provided each pot is extinguished in its entirety. You can access unlimited occupational pensions in this way without being hit with an annual allowance cut.

“It’s also important to remember not all pension income will trigger the MPAA. Buying a lifetime annuity or receiving a defined benefit (DB) income, for example, will not result in an annual allowance reduction.” 

  1. Emergency tax on flexible withdrawals: How to get your money back in 30 days

“The Chancellor might have addressed the hideous complexity of the lifetime allowance, but there are still parts of the pension tax system that don’t work as they should. One of those is the tax treatment of your first withdrawal.

“The first flexible payment you take from your pension will usually be taxed on an emergency basis by HMRC (as will, from 6 April, any excess over the lifetime allowance paid out as a lump sum).

“This means the Revenue assumes you are making 12 withdrawals rather than just the one, with the upshot being you are likely to be significantly overtaxed – potentially by thousands of pounds.

“If you want to get this money back you can do it through your self-assessment tax return, or by filling out one of three forms:

  • P50Z – if the payment used up your pension pot and you have no other income in the tax year
  • P53Z – if the payment used up your pension pot and you have other taxable income
  • P55 – if you have withdrawn only part of your pot and you’re not taking regular payments

“HMRC says this should get sorted within 30 days provided the correct form is completed. Alternatively, if you do nothing it says you should receive a refund at the end of the tax year.

“At the last count, approaching £1 billion had been reclaimed by savers who filled out one of the three official HMRC forms. However, the actual overtaxation figure is likely to be substantially higher as the evidence suggests most people do not fill out one of the forms.”

  1. Keeping your death benefit nominations up-to-date

“Because pension death benefits are extremely tax-efficient, it is even more important savers wanting to bequeath money to loved ones keep their nominations up-to-date. These nominations are critical as they help ensure any leftover pensions you have are inherited by the right people.

“You can nominate whoever you like to receive your pension on your death. This could be your spouse, children or grandchildren, or you can nominate someone unrelated to you if you wish. You can also leave some, or all, of your pension to charity.

“You don’t need to leave your pension to just one person – you can split it in whatever proportion you like, so each of your beneficiaries receives a share of your pension. 

“Although scheme administrators don’t have to follow your nominations, they have to take your wishes into consideration. 

“Changes in life circumstances such as the birth of a child, marriage or divorce could affect who you want to receive your pension if you die, so the tax year-end provides a useful opportunity to review and revise your death benefit nominations.”

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Marcus De Silva
Date published:
31 / 03 / 2023
Reading Time:
7 minutes