A defined benefit pension (also known as a final salary pension) is usually set up by your employer. It guarantees you a regular income in retirement, usually based on your salary and the number of years you have worked. The level of income may also increase in line with inflation.
On the other hand, defined contribution pensions do not offer you a guaranteed level of income. The amount of money you will have in retirement depends on how much you or your employer has contributed and how well your pension investments have performed.
Usually you and employer can pay as much as you earn each year into your pension, up to a combined total £40,000. This is the maximum that you will receive Government tax relief on – typically referred to as your ‘annual allowance’.
For tax relief purposes – the annual allowance is a limit to the total amount of contributions that can be paid into a ‘defined contribution’ scheme and the total amount of benefits that you can build up in a ‘defined benefit’ scheme. This applies across all the schemes you belong you belong to i.e. ‘not per scheme’.
For high earners with income above £240,000 the tax relief cap of £40,000 is reduced – referred to as tapered annual allowance.
For high earners with income above £240,000 the £40,000 tax relief cap is reduced. For every £2 of adjusted income over £240,000 it’s reduced by £1. The minimum annual allowance will be £4,000.
Pension carry forward lets you pay more than your annual allowance into your pension by ‘carrying forward’ unused allowance from the previous three tax years (as long as you have sufficient earnings). You still will receive tax relief on the payments and it can be useful for those affected by the tapered allowance.
The lifetime allowance is the amount you can hold, across all pensions, over your lifetime. The allowance is currently at £1.073 million.
Your pension is assessed (across all of your pension pots) against the allowance when you take benefits, die or reach age 75. If you exceed the lifetime allowance, any excess attracts a tax charge. The charge is 25% if it’s withdrawn as income e.g. annuity or drawdown. If it’s taken as a cash lump sum the charge is 55%.
Investments in pensions grow free from Income Tax and Capital Gains Tax. Pension contributions are paid from gross (pre-tax) income. Where tax has already been paid on a pension contribution it is refunded. The taxman will automatically top up pension contributions up to your annual allowance by 25% to cover basic rate tax. Higher or additional-rate tax payers can then claim back any higher or additional-rate tax that they have paid on contributions through their tax return.
You can normally take up to 25% of your pension tax-free – either as a single lump sum or as a series of smaller withdrawals. You can also take a regular income from your pension by making lump sum withdrawals, buying an annuity or setting up income drawdown.
A defined benefit (final salary) pension will usually stop paying an income when you or, if your pension income passes onto a dependant, your dependant dies. A defined contribution pension can be passed on to your beneficiaries. If you die before the age of 75 the pension will be passed on tax-free. If you die after 75, your beneficiaries will pay their usual rate of Income Tax on any money taken from the pension.
Pensions do not usually form part of your estate so they are not charged with Inheritance Tax when you die. However, any income or lump sum death benefits paid from your pension may form part of your estate and therefore be liable to tax.
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