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Danby Bloch: A new tax snag for pensions

A strange anomaly means non-taxpayers looking to take advantage of pension freedoms could be in for a shock.

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In a bizarre new anomaly in the tax system, many non-taxpayers could find themselves paying an effective 40 per cent on extra pension income they decide to take after 5 April. The arithmetic is simple and is set out in the example below, where a non-taxpayer adds just £5,000 taxable pension to her income of £15,600 and pays an extra £2,000 of income tax.

This situation could come as a serious shock to those who decide to exercise their new pension freedoms in the coming tax year – even for quite modest amounts. It will also come as a surprise to many advisers and others providing advice or guidance about pensions and tax.

This new situation for non-taxpayers has arisen because of the Chancellor’s wizard wheeze to cut the starting tax rate on savings income from 10 per cent to 0 per cent. The starting rate comes into play for the first £5,000 of savings income. If a person’s non-savings income (for example, pensions or earnings) exceeds both the personal allowance and this £5,000 starting savings rate band, the nil per cent savings rate will not apply. A fair number of people benefit from the starting rate band because they have relatively low pension income or earnings at or below the personal allowance and they also receive some interest from bank or building societies.

An important point for people to grasp is that their income is taxed in a specific order: first earnings and then savings income. This matters when it comes to determining what income is set against the personal allowance and what income is taxed, so pension income and earned income are first set against the personal allowance and then taxed. If a person’s pension or earned income exceeds the personal allowance, it is taxed at the basic rate of 20 per cent but if any of the first £5,000 of income above £10,600 in 2015/16 is savings income, it will be taxed at nil.

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Savings income includes gross or net interest from bank and building society deposits. It does not include earnings, pensions, rental income or dividends.

How it works

So, in our example, Maisie has pension income of £10,600 and gross savings income of £5,000. She is therefore a non-taxpayer in 2015/16 and her position will be as in table one.

But suppose she decides to take £6,667 of her pension fund and cash it in: £5,000 (75 per cent) would be taxable. She might think the tax would be only 20 per cent. But her actual position would be as in table two.

So Maisie would pay an additional £2,000 of tax on her extra income of £5,000 – an effective 40 per cent tax rate. All the extra income above £10,600 is now taxable. The extra pension income has in effect pushed her savings income out of the tax-free zone of the first £5,000 of income above the personal allowance of £10,600. And she has to pay 20 per cent tax on the pension.

This example shows a rather neat situation – and most people affected will not fit the arithmetic quite so tidily – but the principle will be the same. Extra pension income will displace savings income in the priority of what gets taxed first. The effect will be that some savings income will be pushed out of the magic tax-free zone of the first £5,000 of savings income above the personal allowance (or any other income tax reliefs).

Impact on pensions

What makes this anomaly so important is that this is the first year of the nil tax-rate on this savings income and it has been introduced at the same time so many more people can get their hands on relatively large slabs of taxable income by freely accessing their pension funds. 

All advisers need to understand this basic principle and not assure people blithely they should not worry about the impact of tax just because they have low incomes. Maisie’s pension pot was less than £7,000.

Advisers also need to build the example into their explanations of how tax impacts on pensions. Tax is probably going to be the main driver for getting advice on the new pensions freedoms. Many people do not understand it and will seek advice. They will get good value for money, which they will really understand and appreciate, even for people with relatively small pots.

Then there is the question of what to do about it. Some possibilities are:

1. Recommend postponing taking benefits or at least some of them or spread them.

2. Get more flexibility by using flexi-access rather than the new uncrystallised funds pension lump sums.

3. If the deed has been done and the money cannot be returned to the provider, it might be possible for the client to generate some offsetting tax relief. For example, they could make a charitable donation that qualifies for gift aid. Or they could even make a pension contribution if they are under 75 years old. Even if they have no earnings they can contribute a gross £3,600.

Danby Bloch is editorial director of Taxbriefs Financial Publishing

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