Some of the most commonly asked questions regarding pensions and tax are outlined below.
1. How does emergency tax work?
Normally the first income paid from a pension will have emergency tax applied to it, as the pension provider will need to contact HMRC to get the right tax code for the person taking the pensions.
As there is no tax code at the time the pension is first taken, emergency tax must be applied to it.
This can sometimes result in an overpayment of tax on the first payment, however HMRC will usually issue a revised tax code following the first payment. This will mean that the overpayment is corrected when the next payment is made.
2. What triggers the Money Purchase Annual Allowance (MPAA)?
The MPAA is a reduced annual contribution allowance. The triggers for this are when someone first accesses a pension flexibly via one of the following routes:
- taking an uncrystallised funds pension lump sum;
- taking income from a flexi-access drawdown pot;
- taking capped drawdown income above the Government Actuary Department maximum;
- being in flexible drawdown prior to 6 April 2015;
- taking a stand-alone lump sum where the individual has primary protection;
- taking out a flexible annuity;
- taking a scheme pension from a scheme with fewer than 12 members.
No other methods of withdrawing a pension are triggers for the MPAA.
3. How is the Lifetime Allowance (LTA) charge applied to Defined Contribution (DC) schemes?
The first issue is that the LTA charge will only apply once someone has used up 100% of the LTA; the standard LTA is £1,073,100 in the tax year 2020-21, though some people may have a higher, protected LTA. It does not matter what size the pension pot is, it is the value of the pension that is crystallised that matters.
Once 100% of the LTA is used up, the pension holder will then normally have a choice as to how they can take any LTA excess:
- They can keep it in the pension system through an annuity or drawdown; or
- They can take it as an LTA excess lump sum.
Both the individual and the pension provider (Scheme Administrator) are jointly liable for the tax charge during the plan holder’s lifetime. Generally most pension providers will deduct the LTA charge from the scheme and send it to HM Revenue & Customs (HMRC), although the individual would still need to declare this on their tax return.
If the income option is taken, an LTA tax charge of 25% applies, and any income taken is taxable at the individual’s marginal rate.
If they choose the lump-sum, a standalone LTA charge of 55% will apply and the money is out of the pension system and in their bank account with no additional tax.
This is a complex area that requires qualified financial advice.
4. How is the Lifetime Allowance charge applied to defined benefit (DB) schemes?
Primarily it is vital to check the scheme itself, as many will treat this differently. For DB schemes, the LTA excess charges are the same as for Defined Contribution schemes: 25% for income and 55% for a lump sum.
The key differential is how this is valued for LTA purposes and how the charge can be paid.
5. What happens at age 75 for Lifetime Allowance tests?
When someone with undrawn pension benefits turns 75, the pension will go through one of three benefit crystallisation tests: BCE5, BCE5a or BCE5b.
- BCE5 applies to Defined Benefit Schemes
- BCE5a is a test on funds in drawdown
- BCE5b is for uncrystallised money purchase pension schemes
So a Lifetime Allowance tax charge can become payable at age 75, even when no benefits are drawn from the scheme. If a charge becomes due it is always at 25% of the amount treated as being crystallised over the individual’s Lifetime Allowance.
These are usually the last Lifetime Allowance tests that an individual will face, though under certain circumstances additional tests can occur within a DB scheme after age 75.
6. Passing DC pension pots to loved ones on death
This can be an issue that some people may face if they have sufficient income from elsewhere, such as from a DB pension that easily meets their income requirements, and an uncrystallised Defined Contribution pension pot.
Since the money is “surplus” to requirements, it may appear that the pension is a good way to pass money to loved ones.
As long as there are no issues relating to the Lifetime Allowance, the main point to consider is how death benefits are taxed. If the individual dies under age 75, then this is usually passed tax-free to the beneficiaries for the whole pot.
However, if the member dies over 75, the whole pot will be taxable at the marginal rates of the beneficiaries. In other words, that tax-free entitlement will die with the member.
There are a number of ways of dealing with this and Westerby Investment Management can provide guidance through this complex area.
7. How can an individual get tax-free cash after age 75 if there are no Lifetime Allowance tests?
Tax-free cash can be paid after age 75, but the individual must have some LTA available. Essentially the individual can take tax-free cash of up to the lower of 25% of the amount being designated to provide benefits or 25% their remaining LTA (ignoring any LTA used by BCE5, BCE5a and BCE5b).
8. Is there a good reason for individuals over the Lifetime Allowance to continue making payments to a pension?
There are a number of factors to consider such as their tax rate, both now and when benefits will be taken, as well as any employer pension contributions that may apply.
If there are employer contributions being made, then this could be viewed as “free money” in a pension, although seeking professional advice when consider this course of action is essential to ensure that no unnecessary tax liability is generated and that it will ultimately benefit the individual.
Please speak to your contact at Westerby Investment Management if you wish to discuss any of the issues highlighted.