General principles: overview of pensions taxation: the basics
Pensions taxation lifecycle
The taxation of registered pension schemes and their arrangements can broadly be divided into three stages:
- investments, and
- taking benefits.
Payments are made into a fund by individual members and often by their employer too. Tax relief is available on those contributions giving an incentive to make adequate retirement provision for later in life.
The fund into which the contributions are paid is invested with the aim of generating income and capital investment returns in order to provide retirement benefits at the relevant time. In money purchase arrangements the investment risk is borne entirely by individual members, whereas in defined benefit arrangements it is borne by the employer (and occasionally the member).
At a future date individuals will take benefits from the fund. Historically, benefits have often been taken as a tax free lump sum (pension commencement lump sum) and regular income payments that are either paid by the scheme or through an annuity purchased from an insurance company.
However, from 6 April 2015 the way in which individuals may access their money purchase pension savings has changed. The Taxation of Pensions Act 2014 made a number of changes to existing pensions tax legislation relating to how registered pension schemes can provide benefits to members. The changes give individuals greater flexibility with how they can take benefits from their money purchase arrangements from age 55 (often referred to as ‘pensions flexibility’).
From 6 April 2015, individuals who have reached the normal minimum pension age (age 55) can access as much of their pension savings in money purchase arrangements as and when they want. Individuals who take advantage of the new flexibilities will trigger the money purchase annual allowance rules. From that point onwards their pension savings in money purchase arrangements will be subject to a specific ’money purchase’ annual allowance.
Broadly, the new flexibilities mean that from 6 April 2015 benefits from a money purchase arrangement under a registered pension scheme can be taken from age 55 by choosing one or more of the following options:
- taking a lifetime annuity
- designating some or all of the money purchase funds to provide a drawdown pension
- a scheme pension
- taking an uncrystallised funds pension lump sum.
With the first three options the pension payments are taxable and the member can also choose to take a tax free pension commencement lump sum when they first start their pension.
With the fourth option - the uncrystallised funds pension lump sum - part of the payment is tax free and part is taxable as ‘pension income’. This reflects the fact that the member cannot be paid a pension commencement lump sum in connection with an uncrystallised funds pension lump sum.
Further information on how individuals may take their scheme benefits can be found at PTM060000.
Exempt, Exempt, Taxed
The UK’s system of pensions tax relief is described as Exempt, Exempt, Taxed (E, E, T), the three letters corresponding to the above three stages in the taxation of pension schemes/arrangements. The first ‘E’ relates to the contributions stage, the second ‘E’ to the investments stage, and the ‘T’ to the taking benefits stage:
Exempt (E) - tax relief is available on individual and employer contributions to registered pension schemes. For individuals, tax relief on their contributions is available at their marginal rate and their employer’s contributions are not treated as a taxable benefit in kind. Therefore, employer contributions are not subject to income tax or corporation tax. There are limits to the amount of relief allowed.
Exempt (E) - most investment growth of the assets held within registered pension schemes is exempt from income and capital gains tax.
Taxed (T) - Most payments to scheme members are liable to income tax - see PTM024600. When a member starts taking their pension they can normally choose to be paid up to 25 per cent of their pension pot as a tax-free pension commencement lump sum with the remainder as taxable pension. As an alternative, the member can be paid an uncrystallised funds pension lump sum, normally 25 per cent of this is tax-free with the remainder liable to income tax.
Tax reliefs and exemptions
The following tax reliefs and exemptions are available in respect of registered pension schemes:
- tax relief on member contributions -see PTM044000,
- tax relief on employer contributions - see PTM043000,
- tax relief on income and gains from most investments in the scheme - see PTM121000,
- certain lump sum benefit payments and lump sum death benefits are exempt from tax - see PTM060000 and PTM070000,
- contributions into and payments from a registered pension scheme are generally exempt from inheritance tax.