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In this article we are going to explore how your pension is taxed, how your pension income interacts with any other income you may have and finally we will look at some of the biggest mistakes we see retirees make when it comes to taking an income from your pension via flexi access drawdown.
How your pension tax free cash works
Starting with your pension tax-free cash, as you may know, you can typically take up to 25% of an uncrystallised pension tax-free. This is known as a pension commencement lump sum. You don’t have to take it all at once; it’s possible to take a series of smaller tax-free lump sums or even as a tax-free monthly income.
Let’s use the example of a £100,000 pension.
When you come to take your tax-free cash, then this crystallizes your pension, which I found to be an extremely complex concept when I first heard of it. If you haven’t taken any income or tax-free cash from your pension, then your pension is known as uncrystallised.
So if John takes all of the tax-free cash from within his pension, then he crystallises 100% of the pension fund. £25,000 would be paid to him, and the remaining funds would be crystallised within the pension.
He would be able to take income from these funds, but any income that he would take would be subject to income tax. If you take all your tax-free cash, that makes sense. But what happens if you only take some of your 25% tax-free cash if you don’t need all of it? Do you lose the rest?
What about if you only take some of your pension tax free cash?
So let’s use the same example, but John only takes £10,000 tax-free cash. When John takes his £10,000 tax-free cash, he ‘crystallises’ £40,000, or 40% of his pension. £10,000 is taken as tax-free cash, and £30,000 is designated to crystallised funds within his pension, which, if you remember, he can still withdraw at a later date, but these funds would be subject to income tax at his marginal rate. 60% of his pension would still be uncrystallised, which means he can take 25% of whatever the uncrystallised amount is in the future, tax-free.
Using the same example, but John leaves the remaining pension for eight years, and his pension has grown to £150,000. How much tax-free cash does he have remaining?
Is it still £15,000? No. The pension is now worth £150,000 and 60% is uncrystallised which equates to £90,000. He can take 25% of this amount tax free, means he can take £22,500 as a tax-free lump sum. He will crystallise £90,000, with £22,500 paid as a tax-free lump sum and the remaining £67,500 moving to the crystallised side of his pension. If you remember, he can take his crystallised funds, but these will be subject to income tax at the time the funds are withdrawn.
How does the taxation of your crystallised pension work?
Once you have taken all of your tax-free cash, then you will have crystallised your total pension fund. Once you take any crystallised funds, these will be classed as taxable income and taxable at your marginal rate.
Does that mean you automatically pay tax on the withdrawal, and if so, at what rate? Not necessarily. This is because it will depend on what other taxable income you may have, such as your state pension, final salary pensions, employment income if you are still working, and rental income. Don’t forget that the vast majority of people will have something called their personal allowance. This is where the first £12,570 of your taxable income is taxed at 0%.
Assuming you have no other income, if you take £12,570 of your income from your crystallised pension, even though this is taxable income, as it is within the personal allowance, the effective tax rate would be 0%—so effectively tax-free.
Drawdown and the different tax brackets
So let’s assume you have used all of your personal allowance, and you take a taxable withdrawal from your pension. How much tax are you going to pay? To answer this, we need to explore the various tax bands and tax rates.
If you live in England, Wales, or Northern Ireland, there are effectively three tax bands and rates that you can pay tax at: Basic Rate, Higher Rate, and finally, the Additional Rate.
Basic Rate Tax explained and example
Starting with the Basic Rate, the basic rate tax threshold is £50,270. This means any income above the personal allowance but within this threshold amount of £50,270 is taxed at the basic rate of 20%.
Let’s see how that works. George is still working, and his employment income is conveniently £12,570, which takes up all of his personal allowance, which is taxed at 0%. He takes £5,000 as a lump sum withdrawal from his crystallised pension fund, which, if you remember, is classed as taxable income, so the basic rate tax due will be £1,000.
Higher Rate tax and Additional Rate Explained
How about if your flexi access drawdown income pushes you over the basic rate threshold? Well, any income between £50,270 and £125,140 is taxed at 40%. Finally, if you have any income above £125,140, this is taxed at 45%. So what happens if you straddle one or more tax bands? Let’s see how that works.
John is about to retire. His only income is going to be his state pension, which is the full amount. In addition to that, he has a private pension valued at over £1,000,000. This is now fully crystallised as he used the tax-free cash to buy a Lamborghini. He needs an extra £60,000 to meet his expenditure. In total, his income is going to be £71,500. So what tax will he pay on his income?
He has his full personal allowance remaining, so we need to take £71,500 and deduct the personal allowance amount of £12,570, as this is taxed at 0%.
This means £58,930 of the income will be subject to tax. We take the basic rate threshold of £50,270 and deduct the personal allowance of £12,570 from this, which means £37,700 of the income is taxed at 20%, so the basic rate tax due is £7,540.
What about the rest of the income that is above the basic rate threshold? We take £71,500, deduct the basic rate threshold of £50,270 from this, and so £21,230 is going to be subject to income tax at 40%.
This means the higher rate tax will be £8,492. Therefore, the total tax payable will be just over £16,000, and his net income will be £55,468. His effective tax rate is around 22%, despite, of course, being a higher rate taxpayer.
Reduced personal allowance if earnings over £100,000
To add further confusion to the fire. If your earnings are above £100,000, then your personal allowance is reduced by £1 for every £2 over this limit.
In other words, if your income exceeds £125,140, then your personal allowance—the amount of income which is taxed at 0%—is removed entirely.
This is often referred to as the 60% tax trap, as not only is the income being taxed at 40%, but you are also losing some or all of your personal allowance, meaning the income that was previously tax-free is now subject to tax.
The biggest taxation mistakes with Flexi Access Drawdown
1) Not structuring drawdown income tax efficiently
The first biggest mistake I see is when somebody simply takes their tax-free cash from their pension on the basis it’s tax-free without due regard for considering their tax status and other income.
Let’s take Sandra as an example. She is 65 and a year away from her state pension and has no other income. She plans on taking £10,000 from her pension to meet her expenditure before her state pension kicks in.
Without much thought, she takes this from her 25% tax-free cash. However, as she has no income, she has her personal allowance remaining available, which, if you remember, means the first £12,570 of her taxable income is taxed at 0%—so tax-free. The opportunity cost of Sandra needlessly using her tax-free cash to fund the £10,000 withdrawal rather than taking advantage of her personal allowance would be as much as £2,000 if we assume she was a basic rate taxpayer in the future.
2) No tax planning when income exceeds £100,000
The second mistake I see, which is not technically to do with pension drawdown withdrawals, relates back to if you are fortunate to earn over £100,000 and how your personal allowance is then reduced by £1 for every £2 of income over this threshold.
Not only is this income taxed at 40%, but as the personal allowance is reduced, the effective tax rate is 60% as the personal allowance is withdrawn. So what can you do about it?
Let’s take Margaret. She has a salary of £100,000 and is due to receive a bonus of £10,000.
When you factor in the 60% tax trap that she finds herself in, the net, after-tax money she would get on this bonus would actually only be £4,000, without even considering national insurance tax, which would be a further dent in this net amount. So what can she do instead? Margaret, if her employer agrees and she has the annual allowance available to do so, could pay this into her pension as an employer contribution.
If she really needed the money, she could withdraw this as a tax-free cash payment, and if she did, she would have the full amount of £10,000 rather than the £4,000 that she would have had if she just simply took this as a bonus.
A further potential cherry on the cake is that by paying the bonus into her pension, her employer will save on the employer National Insurance Tax, which would be as much as 13.8% of the bonus, or potentially £1,380. If her employer agrees, of course, they may agree to pass on this NI saving, and so the actual contribution would be £11,380! Not bad at all when you consider the net bonus would be just £4,000 if she just took it as a simple bonus through PAYE.
3) Not combing tax free cash and taxable funds
The final mistake I often see is that people don’t realise you can take a combination of both your tax-free cash from your uncrystallised pension and also take taxable income from the crystallised side of the pension.
Let’s see an example of how someone could take £24,000 tax-free.
Terrance can withdraw £12,570 from his crystallised funds, which will be subject to income tax. But hold your horses—although these funds will be subject to income tax, as it is up to his personal allowance, the income tax will be 0%, and no tax will be due on the withdrawal.
Okay, so we know he needs £24,000, and if he takes £12,570 from his crystallised funds, then he will still have a shortfall of £11,430. How can he make up the difference? Terrance can simultaneously take the shortfall amount of £11,430 from his tax-free cash. By doing this, his effective tax rate on the combined withdrawal would be 0%.
Seek pension advice from the specialists at Heritage Financial Planning
If you are considering your retirement options and thinking about how to take your tax-free lump sum from your pension savings, it is wise to get professional, independent advice. Contact Heritage Financial Planning today to book a call with one of our knowledgeable and friendly financial advisers.
The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a guide to the future. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.
