Learn more about the tax advantages of a pension, and how tax rules can be used to boost your pension pot
One of the main benefits of a SIPP is tax relief. For any contributions you make into your SIPP, the government will top it up with 20% in tax relief. If you’re a higher or top-rate taxpayer, you can claim back up to an additional 25% on your tax return, depending on your base tax contributions. Scottish taxpayers can claim back up to an additional 26% on their tax return, potentially bringing their total tax relief to 46%.
Accumulated investments within SIPPs grow free of income tax, while if you choose to sell or dispose of any investments, you won’t have to pay capital gains tax.
Tom is a basic rate taxpayer with £10,000 to invest. He puts the full amount into his SIPP. The government provides Tom with 20% tax relief, depositing an additional £2,500 into his SIPP, bringing the total to £12,500. As Tom is a basic rate taxpayer (20%) he can’t claim any more tax relief, but it has cost Tom just £10,000 to save £12,500.
Daisy is on a 40% tax-rate and also has £10,000 to invest. Like Tom, she also puts the full £10,000 into her SIPP. The government will still provide 20% tax-relief (£2,500), deposited straight into her pension. However, Daisy can also claim back an additional 20% on her tax return, taking her total tax relief up to £5,000. All in all, it cost Daisy just £7,500 to save £12,500 in her SIPP.
Tax relief is a very attractive concept, and as a result the government limits the amount you can claim. If you’re still working, you can claim tax relief on contributions equal to 100% of your earnings in any given year – with the annual allowance capped at £40,000. However, if you have contributed less than this in the three preceding years, you may be able to use the carry forward rules, bringing your annual allowance up to a maximum of £120,000.
If you are not earning at all, you can still receive some tax relief on pension savings. Non-taxpayers can put up to £3,600 into a pension each year and receive tax relief. This equates to a personal contribution of £2,880, to which the government adds £720 (20%). There is no age restriction on starting a pension, so some people choose to start SIPPs for non-earning children and benefit from tax relief.
Once retired, you can put up to £4,000 into your pension each year and continue to benefit from tax relief.
Once you’ve retired, you can access 25% of your pension tax-free. There are a variety of ways you can access your pension, each taxed at 25%.
If you decide to drawdown, you can take a 25% lump sum from your pension savings tax-free. The remaining 75% will be taxed at your marginal tax rate as and when you drawdown on it.
If you choose the uncrystallised funds pension lump sum (UFPLS) method, for each lump sum you withdraw, 25% will be tax-free and the remaining 75% will be taxed at your marginal tax rate.
If you purchase an annuity, you will receive a steady stream of income for the rest of your life, of which 25% of the income will be tax-free, and you will only pay tax on the remaining 75%.