Pensions are an effective, tax-efficient way to save money for retirement. But you may be wondering if your pension will count towards your taxable income and how much tax you owe. If so, read on!
Generally, you won’t have to pay any tax on your pension until you take it out. This includes the first 25% of your lump sum and any withdrawals.
Tax-free lump sum
Tax-exempt lump sums from pensions can be an attractive choice for many people. They could help clear debt, make home improvements or buy a new car – all of which could save you money in the long run.
Before taking a lump sum from your pension, it’s essential to understand how the cash will be taxed. You won’t pay tax on the first 25% of any pension lump sum you withdraw; however, anything above this threshold will be subject to ordinary income taxation.
For instance, if your pension pot is worth PS12,570, the first PS12,570 will count towards your personal allowance. After that, taxation on any remaining amounts depends on your total income and allowances.
The key to maintaining your pension savings is keeping them out of a tax-inefficient environment. This ensures any growth is exempt from Capital Gains Tax or Income Tax and you can pass on investments to family members without incurring Inheritance Tax.
Tax on withdrawals
When taking a lump sum out of your pension, you will usually have to pay tax on the full amount regardless of what income tax band you fall within.
Tax-exempt amounts such as lump sums are limited to 25%; any remaining portion must be taxed at your marginal rate. If you withdraw more than this, however, you’ll have to pay tax at your marginal rate.
Saving for retirement through taking money out of a pension can be beneficial, but it’s essential to remember that doing so could result in paying more tax than necessary.
Due to the potential for a pension to exceed its lifetime allowance, you may have to pay additional taxation.
The government wants to motivate people to save for retirement by offering them the option to take a portion of their savings tax-free at retirement. This can be accomplished through various methods such as phased drawdown or individual lump sums (UFPLS). However, you should always seek financial advice before making any withdrawals.
UK tax
In the UK, pension saving is taxed using an “exempt, exempt, taxed” model (EET). This means savers’ contributions and investment growth are tax-exempt but when they withdraw their savings they are taxed like other income. Opponents argue this system is costly and disincentives people from saving into their pensions; on the other hand proponents maintain it’s fair and provides a valuable tax break.
There are certain limits on the amount of tax relief you can claim, such as an earnings threshold and annual allowance limit. In the UK, if you earn more than PS3,600 a year, tax relief cannot be claimed on pension contributions made to an IRA or similar plan.
When you make your own pension contributions, the government usually grants 20% tax relief at the basic rate of tax. This is known as relief at source and it works differently for higher and additional rate taxpayers. If you fall within this bracket, however, you can claim an additional 25% by filing in a self-assessment tax return.
Staggering
Tax laws and legislation evolve over time, making it essential to comprehend how taxes impact your pension. For many people this means that when they take money from their pension they must pay income tax on it.
Fortunately, this isn’t always the case. In many cases, you can take some or all of your pension savings tax-free if done correctly.
Tax relief on contributions can be obtained in two ways: ‘net pay’ arrangement and’relief at source’. For those on lower salaries, the former option is preferable as it will ultimately save you money in the long run.
A’relief at source’ arrangement means your employer will add 20% tax relief to your pension pot, giving you a tax refund without having to pay it upfront. Not only this, but it could also enable you to take larger lump sums later on in life if desired.