Pensions: avoid the traps
Paul Garwood of Smith & Williamson explains why it’s important to check your pension regularly to make sure it’s on target to meet your needs in retirement.
Pensions have long been an integral part of people’s financial planning. Their primary attraction has been the range of tax breaks available, compared to other forms of saving or investment.
However, people are increasingly likely to find they have unwelcome tax liabilities when they fill out their annual tax returns or come to take their benefits.
Here’s an overview of the advantages and tax traps of paying into a pension scheme. It highlights the importance of reviewing your pension arrangements regularly.
- Income tax relief on contributions up to the highest marginal rate of income tax paid
- Tax-advantageous investment growth within the pension fund
- The ability to take lump sums free of income tax at retirement
- On death, the ability to pass funds to named beneficiaries in an income tax and inheritance tax-effective manner.
If pension contributions exceed the maximum allowable in a tax year, any excess contributions will be taxed as additional income and subject to income tax at the highest marginal rate. The annual allowance fell from £255,000 to £50,000 last tax year and this could mean some taxpayers find they have an unexpected tax bill when completing their annual tax returns.
The current maximum lifetime allowance is £1.5m. If a pension scheme provides more benefits than the lifetime allowance the excess will be liable to a tax charge of 55%.
It is therefore possible that some individuals, or their employers, are making payments into what are supposed to be tax-effective investments only to find a proportion of the contribution is subject to income tax of 50% and that the benefits bought by this contribution are subject to a 55% tax recovery charge. Not the tax-effective savings vehicle they had been expecting!
Importance of regular review
It is clearly important to assess the likely tax treatment of employer and personal pension contributions before they are made, rather than wait until a large unexpected tax demand arrives. Other issues to consider are as follows:
Many people’s pension funds are their largest asset and yet they have left their pension pots in poorly performing funds for years. As people get older and their circumstances change, are the funds still appropriate?
How benefits are taken
It has not been a requirement to buy an annuity with your pension fund for many years, yet many plans don’t make investors aware of the possible alternatives to annuity purchase if benefits are taken with them.
Falling annuity rates
Is your pension going to provide the benefits you expected? Annuity rates have plummeted over the past 20 years. According to Prudential, the current maximum lifetime allowance of £1.5m will now only buy a married couple aged 60 an index-linked pension of £28,703pa* assuming no lump sum is taken.
There has been a torrent of pension changes recently. Can your pension still provide what you want? Are there new opportunities you are unaware of?
In summary, in an increasingly complex pension environment, regular review is vital to ensure you’re on target to meet your income requirements.
*Rates accurate as at 12/07/2012. Pension is payable monthly and reduces by a third on first death.
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