With the fallout from the coronavirus pandemic dominating the agenda and hitting investors in the pocket, it has never been more important to make the most of the tax breaks available and avoid potential bear traps.
Tom Selby, Senior Analyst at AJ Bell, considers five key things retirement savers need to be aware of.
1. Don’t miss out on free money
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.
If you’re a member of a workplace pension scheme you’re also entitled to an employer match on at least your first 3% of qualifying contributions – so effectively a 100% bonus on the money you save for retirement. You can also access 25% of your fund tax-free from age 55.
While many people will understandably be struggling to think beyond the next weeks and months at the moment, the combination of tax relief, tax-free cash from 55 and a matched employer contribution makes pensions a difficult investment to beat. Those who can afford to should consider making the most of their available allowances.
2. Boost your pensions annual allowance to £160,000
The amount you can save in a pension each year has been eroded from a high of £255,000 in 2010/11 to £40,000 today. This is still double the ISA allowance, and there is a tax trick you can use to boost it even further.
Pensions ‘carry forward’ rules allow you to use up to three years of unused allowances in the current tax year. So if you didn’t pay anything into a pension in the 2017/18, 2018/19 or 2019/20 tax years, you could carry forward £120,000 of unused allowances and add them to this year’s £40,000 allowance.
This flexibility is particularly useful for business owners or anyone who is trying to make up for lost time saving for retirement.
3. Beware the pension freedoms tax trap
Hundreds of thousands of savers have flexibly accessed their retirement pot each year since the pension freedoms launched in April 2015. And with the economy taking a battering and jobs potentially at risk as a result of the coronavirus outbreak, it is likely more over 55s will need to turn to their pension to plug a short-term income gap.
All those who made a taxable withdrawal (i.e. more than the 25% tax-free lump sum) have had their annual allowance savagely cut, from £40,000 to just £4,000 – and there is no going back. This reduced annual allowance is called the Money Purchase Annual Allowance (MPAA). Furthermore, they lose the ability to carry forward any unused allowances from previous tax years.
The Treasury introduced this measure to stop people recycling large sums of money through pensions to benefit from extra tax-free cash.
People planning to access their pension flexibly need to think carefully about the impact it will have on their ability to save in the future.
Anyone wanting to access their pension but concerned about triggering the MPAA should consider whether just taking their tax-free cash could be sufficient, particularly where they are planning a one-off purchase rather than taking a regular income.
4. Get your affairs in order
The pension freedoms weren’t just about flexibility in retirement - changes to the way your retirement fund is taxed on death mean pensions are now attractive tax planning vehicles. If you die before age 75 your fund can be passed on to your beneficiary tax-free, while if you die after 75 it is taxed in the same way as income when your beneficiary draws an income.
Furthermore, if your beneficiary dies before age 75 they too can pass on any untouched funds, even if you died after age 75.
This makes it even more important to make sure your pension goes where you want it to go should the worst happen. 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.
5. Reclaim any overpaid tax on pension freedoms withdrawals
The first flexible payment you take from your pension will be taxed on an emergency basis, referred to in HMRC jargon as ‘Month 1’.
This means HMRC 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. At the last count over £500 million had been reclaimed by savers who had filled out these forms.
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