The Facts about Tax on Pension Lump Sum Payments
Calculating the tax on pension lump sum payments is pretty straightforward at its root. In the simplest terms possible, savers are allowed to take the first 25% of their pension pots free of income taxes. The remaining 75% is taxed at the individual's marginal rate when added to annual income. The tax rules apply whether a pot is taken all at once or in incremental payments.
As a side note, the pension tax-free lump sum is not added to the annual income for the purposes of taxation. Nevertheless, how this money is reported is dictated by how you receive pension disbursements. An experienced and certified financial advisor can explain the details of how it all works.
Here are five additional facts you need to know about pension lump sum payments and their tax implications:
Fact #1 – The Annual Allowance and the Money Purchase Annual Allowance
Given the many tax advantages that are available with regard to funding a personal pension there are limits to the tax-relievable contributions that can be paid. Individuals are able to make contributions of up to the greater of £3,600 or 100% of their annual earnings to all of their pensions each tax year and receive tax relief on them.
There is an annual limit on the total amount of pension contributions that each person can make without incurring a tax charge (this includes employer and employee contributions). This is called the Annual Allowance. Where the total employer and/or individual contribution exceeds the Annual Allowance a tax charge will apply. Depending on your taxable income the excess pension savings can be charged to tax in whole or in part at 45%, 40% or 20%. For the 2016/17 tax year the Annual Allowance has been set at £40,000. However it may be possible for contributions in excess of the Annual Allowance to be paid in some circumstances under the rules which allow unused Annual Allowance from the 3 previous tax years to be brought forward and added to the current year’s Annual Allowance.
From 6 April 2016, individuals who have adjusted income (income plus employer pension contributions) for a tax year of greater than £150,000 will have their annual allowance for that tax year restricted. It will be reduced, so that for every £2 of income over £150,000, their annual allowance is reduced by £1.
The maximum reduction will be £30,000, so anyone with income of £210,000 or more will have an annual allowance of £10,000. High income individuals caught by the restriction may therefore have to reduce the contributions paid by them and/or their employers or suffer an annual allowance charge.
The tapered reduction doesn't apply to anyone with threshold income (income less personal pension contributions) of no more than £110,000.
Fact #2 – The Death Tax Rate has Been Reduced
It is more attractive to pass on the funds remaining in a pension account to beneficiaries upon one's passing. How the funds are taxed depends on if you have taken any benefits from your pension fund and whether or not you die before age 75. Details are shown below.
What happens to your pension fund if you have not taken any benefits and you die before age 75
If you die before age 75 the following will apply to your beneficiaries
- If they opt to take the fund as a lump sum, the payment will be tax free provided it is paid out within 2 years of date of death.
- If they opt to take the fund as income drawdown or an annuity, any payments will be tax free, provided its designated within 2 years.
What happens to your pension fund if you die after age 75
If you die after age 75 the following rules will apply to your beneficiaries
- If they opt to take the pension as a lump sum, this will be subject to a tax charge of 45%
- If they take the pension as an income, the payments will be taxed at their rate of income tax.
If you have taken the UFPLS and have not spent it, this will form part of your estate and will be assessable for Inheritance Tax.
It may be prudent to consider who you wish to receive the payments in the event of your death, depending on their individual circumstances.
Fact #3 – Trivial Commutation Is Now More Attractive
If you meet the following conditions, it may be possible for you to take all your benefits from a defined benefit pension scheme as a lump sum (known as a trivial commutation lump sum):
- The value of all your pension rights from all registered pension scheme sources (including the value of existing pensions in payment) must be £30,000 or less; and
- You are aged 55 or above; and
- You have some unused lifetime allowance left; and
- The payment eliminates your defined benefit rights under the scheme in question; and
- The payment is made within 12 months of your first trivial commutation lump sum being paid (if applicable and not including any trivial payments paid before 6th April 2006).
In addition to the above, if you are aged over 55 and have any small occupational and/or non-occupational pension pots with values of £10,000 or less each, you may be able to take those as lump sums irrespective of the value of your overall pension benefits. The number of small pots you can take in this way is restricted to three for non-occupational pensions (such as personal pensions, retirement annuities, stakeholder pensions) but is unlimited for occupational pots (such as final salary schemes, occupational money purchase schemes and public sector schemes).
If you have not previously taken benefits from the scheme paying the lump sum, only 75% of the lump sum will be taxable (as pension income). The other 25% will be paid tax free. If the lump sum is being paid from pension savings that you have already put into payment the whole lump sum will be taxable as pension income.
Fact #4 – Unauthorised Payments Still Subject to Punitive Taxes
There are, unfortunately, scam artists who are attempting to take advantage of the initial confusion generated by pension reform. These individuals are counting on the fact that the average pension saver still does not fully understand how the new pension rules affect him or her. They are getting away with hundreds of thousands of pounds in fraudulent transactions. If you forget all the rest of the tax facts we have offered here, remember this one: unauthorised payments from a pension scheme are still subject to the same punitive taxes.
What is an unauthorised payment? It is any lump sum payment taken from a pension scheme prior to age 55. There are three exceptions to this rule; information on these three exceptions can be found by visiting the HMRC website. Outside of the three exceptions, the minimum tax penalty on unauthorised payments is 55%. You may be subject to taxes as high as 70% should you fail to inform the Government of your payment or you attempt to conceal it.
Fact #5 – QROPS Still More Attractive To Ex-Pats
There was some early speculation and hope that pension reform would turn out more attractive options for ex-pats choosing to retire overseas. That is not the case. Whether or not the tax environment is more friendly in your case would require knowing and understanding the income reporting and taxation rules of the country you intend to retire to.
As an example, the US Internal Revenue Service (IRS) requires ex-pats to report all of their pension income if they are legal residents. Leaving your pension fund in the UK would subject you to taxation by both governments. Failing to report the income to the IRS in order to save on your tax bill could result in substantial fines if you were caught.
In such a case, it would be beneficial to take your 25% tax-free lump sum prior to leaving the UK then transfer the remaining monies into a QROPS. If you wait to take your 25% lump sum until after you move, you could be subject to taxation in the US.
Calculating the tax on pension lump sum payments can be fairly easy if your financial circumstances are simple. Nonetheless, more complex situations involving multiple pensions, equity investments, and other sorts of retirement income will obviously make calculations more difficult. Your best course of action is always to seek out the assistance of a certified financial advisor who can help you make sense of it all. You might also take advantage of the free government guidance provided by a number of agencies including the Pensions Advisory Service and Citizens Advice.
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