Hidden in Plain Sight! Unknown Facts (Pension)

,??It is so important to be intentional about our personal finances. Without that, we believe we know what is necessary to know, without actually knowing what we don’t know! A lot of information is available in the public domain, but because we aren’t looking for it, we are blind to it – so this week I bring to the fore, a couple of unknown facts about pension which are actually hidden in plain sight!

Unknown Known Fact I: Deferred Tax on Pension

So did you think when you draw down your pension it wouldn’t be taxed?

Do you wonder why the government is giving you all the freebies (top-ups, tax relief, etc.)?  My guess is that they do this to encourage us to prepare for the future. Remember, the more financially secure a person is in the later years, the less likely the need for the government to be responsible for their wellbeing or for them to have the need to utilise the benefits available.

Fact: Pension drawdown = Income, therefore it is Taxable! 

Can you believe!  Well, remember your pension was tax deductible i.e. the portion of your income that was pension contribution, didn’t get taxed all those years ago (when you were making the contributions)?  Well, now as you attain the age where you can, and you begin to drawdown those funds, it means it’s time to pay up  and guess what, it is taxed at source by your pension provider (PAYE round two).  So rather than it being non-taxable, tax on your pension contributions is deferred. 

Note however that if your tax was at a higher rate during your years of employment[1], when you attain the age when you can drawdown these funds, you probably would have avoided paying tax at the higher rate as you’d would now be in a position to draw down at a lower tax rate (that’s a PLUS right!). For those who were on a lower tax rate during years of employment, you get the free contribution made by your employer ( also a PLUS!). So there are still benefits to contributing to a pension plan in spite of tax deferral.

As we all know, taxes are necessary (some will argue not and people have different opinions on who should or shouldn’t be taxed) for the government to be able to provide public services like NHS, education, welfare system, etc. and to maintain our roads, and other public infrastructure. The key therefore isn’t to not pay taxes (which is a criminal offence, by the way), as we all benefit from what it’s used for, but to do so efficiently.

More likely than not, by the time you get to the age where you can draw down your pension, even if you are earning income other than your pension[2]  your total income won’t be too much more than your annual basic allowance (i.e. the amount of income you can earn in a year without being taxed) which would mean you pay tax at the lower rate; and if your income is below your annual allowance, you don’t pay any tax. 

I cannot stress enough how important it is to consider tax efficiency when structuring your later year finances.

Unknown Fact II: Lifetime Allowance: In the context of pensions, have you ever come across “Lifetime Allowance” (no, not Lifetime ISA)? Well, while it is fantastic to put money away into a pension, there is a limit above which your pension savings may be liable to a high tax charge!

Fact: Lifetime Allowance (LTA) = the limit the government has set as the total amount you can hold in all your pension pots.

The reason most people aren’t aware of this is probably because most people won’t be affected as their pension savings won’t reach the threshold affected. If people, as I am encouraging, do commence planning for the future and putting money away early, this increases the possibility of reaching/breaching the LTA threshold, so it is only right that I also bring LTA to people’s attention.

In 2020/21 (and is fixed for the next tax year) the threshold is £1,073,100.  If your total pension savings is more than this amount, then you would have to pay tax on the surplus amount once you start drawing from your pension pot.  See what the government say here https://www.gov.uk/tax-on-your-private-pension/lifetime-allowance

The tax rates could also be quite steep (depending on how you decide to draw the funds down)!

• 55% if you draw a lump sum or 25% if you draw any other way e.g. as cash or pension payments

Guess what – the lifetime allowance has been reduced over the years; the 2011/12: £1.8m limit was reduced to £1.5m from 2012/13 and to £1,250,000 from 2014/15.  The most recent reduction was in 2016/17 when it was reduced from £1.25m to £1m; which means more people with large amounts in their pension pots, suddenly found themselves in a position where £250,000 (and above, if applicable) of their savings became taxable at the higher rates – depending on how they drew it down!  The £1m limit has been indexed to inflation since 2018 (hence the extra £73,100 in current limits).

Based on the trend therefore, there is no guarantee that the threshold could be reduced again sometime in the future if the government needs to raise some money (perhaps to pay for all the covid-19 related initiatives like the furlough scheme, for example) and in fact, the 2021 Finance bill sets to remove the index link so the threshold will remain as it is till 2025/26 if the legislation is passed!

There’s however a way to apply for protection of your lifetime allowance, as shown here https://www.gov.uk/guidance/pension-schemes-protect-your-lifetime-allowance, but of course there are conditions attached – check the details out.

So YES, I advocate for planning for the future very early on, but it’s got to be in a tax efficient manner and that’s why financial planning is absolutely important.  The objective is a financially secure future in the most tax efficient manner. 

I am sure you’d agree that it would be great to have heaps of money to draw on in those later years, but in my opinion it is equally important to ensure those funds are held in a manner that doesn’t entail paying high portions of it out in taxes when the time comes to draw it down (or if that has to happen, at least it’s been built into the drawdown plan), especially as prior to draw down one’s spent a lifetime paying unavoidable employment tax!

Did you find this useful?  If so, feel free to share.

[1] As a high rate tax payer, you should reach out to HMRC to claim the extra tax relief, as your employer only makes allowance for basic rate relief

[2] This is more likely now than in previous years, as people work for longer.  There is no retirement age in U.K so employers can’t force an employee to retire, rather the decision is the individual’s. A lot of people therefore chose to carry on working (albeit part-time, in a lot of cases) for social interaction purposes 

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