As the song goes “I got bills, I gotta pay, so I’m gon’ work, work, work every day.” At some point however, people may want or need to give up going to work every day. Even younger people need to think about how they will pay their bills if they are unable to work for any reason.
If you are intending to give up work permanently, it is absolutely crucial to plan ahead. One option is to save into a pension. If you choose this route, it is important to understand your annual and lifetime allowances. It’s also important to be clear on what will happen if you exceed them.
The following explanation applies to defined contributions pensions. Defined benefits schemes may have different rules.
It also applies to the time before you start to make any sort of withdrawal(s) from your pension pot. Once you start withdrawing money, you may trigger different rules. (search: MPAA)
The Annual Allowance
As its name suggests this is the amount you can save towards your pension each year. Generally speaking you can save an amount equal to your earnings, up to a maximum of £40,000.
If you put in more than you earn, then you will only get tax relief to the amount of your qualifying earnings. For example, if you earn £10K pa and put all of this towards your pension along with £5K from another source, you will only get tax relief on the initial £10K. Alternatively if you earn £45K pa and put all of it towards a pension, you will only get tax relief on the initial £40K.
There are different rules for those who are not in paid employment. At current time, those not in work can receive tax relief on pension contributions up to the value of £2,880. They can pay in more than this, but will not receive tax relief on these extra contributions.
The Money Purchase Annual Allowance (MPAA)
Starting this tax year, making withdrawals from pensions can result in your annual allowance being reduced to £10K pa. This is too complicated to discuss further here. It is however worth being aware of this. If you plan to make withdrawals from your pension fund, it is strongly advisable to check how this could affect your annual allowance.
The Lifetime Allowance
This is the amount of pension contributions on which you can receive tax relief over your lifetime. For most people it is currently £1.25 million and will reduce to £1 million in April next year.
If you are currently asking yourself “how can I save money on my pension pot”, then one possible solution might be to ring-fence your lifetime allowance. This is known as individual protection.
As with the MPAA, the rules around this are complicated. They also depend on the type of pension arrangements you have, i.e. defined contributions or defined benefits. If you do have substantial pension savings, however, it could be worth looking into this.
Pensions and Tax
You may also be asking yourself “what tax will I owe on my pension pot?” The answer here is also likely to be, it depends.
If you take any funds over your lifetime allowance as a lump sum, you will be taxed at 55%. If you used funds over your lifetime allowance to generate a regular retirement income, you will be taxed at 25%.
This is in addition to any tax which is due on the income itself. Income from pensions is taxed in the same way as income from employment. Those who have reached state pension age are, however, exempt from paying national insurance contributions, even if they continue to work.