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Annuity taxation
All individuals retiring with appropriate pension rights can
commute part of the pension fund to a tax free lump sum before
buying an annuity. The compulsory
purchase annuity (or pension
annuities) acquired by a pension fund is taxable as earned
income although annuities are not be subject to national
insurance contributions.
This means that for a basic rate taxpayer the tax paid on
the income from the pension annuity is at 20% for the tax year 2014/15.
For higher rate tax 40% would be payable for any amount
above the higher rate tax threshold of £31,866and for additional tax rate of 45% this would apply for amounts above £150,000, all in excess of any personal allowances.
Any tax free lump sum not commuted will provide an extra income
but will be taxable. It is also possible to acquire a purchased
life annuity with the tax free lump sum post retirement
where part of the annuity is treated as a return of capital
and therefore tax free and the balance is taxed at the 20%
savings income rate.
For example, the following table shows the income a tax free
lump sum from a pension
fund can purchase on a gross and net of tax basis. It
compares using the tax free cash of £100,000 to purchase
extra income from either compulsory purchase annuities or
a purchased life annuity. It assumes that the individuals
are basic rate taxpayers, aged 65 and the annuity is level,
no guarantee, without proportion payable in arrears and both
providing 50% defendants benefits.
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Gross |
Net |
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Pension
annuity, male 65 |
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Life
annuity, male 65 |
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Pension
annuity, female 65 |
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Life
annuity, female 65 |
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Pension
annuity, joint 65 |
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Life
annuity, joint 65 |
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| Annuity table - the annuity rate
shown above is based on a purchase price of £100,000
and should be used as a guide only. For an annuity
rate specific to your circumstances you should complete
the free
annuity quote. |
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In all cases the income from purchased life annuities net
of basic rate tax is greater than from a compulsory purchase
annuity. For example, a couple aged 65 will receive a disposable
income of £6,050 per year from a purchased life annuity
compared to only £5,520 per year from pension annuities.
This means the purchased life annuity provides an extra income
of £530 per year.
If the couple were paying higher rate tax the difference would
be even greater. The net income after 40% tax from a pension
annuity would reduce from £6,900 to £4,140 per
year, compared to a purchased life annuity that reduces from
£6,330 to £5,770 per year and means the purchased
life annuity provides an extra income of £1,630 per
year.
At retirement the individual can use a pension fund to buy an annuity and has the option to use an open market option to search for the highest pension annuity. Once you have purchased an annuity it cannot be changed, so learn more about annuities, compare annuity rates and before making a decision at retirement, secure a personalised pension annuities quote offering guaranteed rates.
Personal pension
With the introduction of Pension Simplification from 6 April
2006, the tax free lump sum from a personal
pension cannot be greater than 25% of the the whole fund.
This can include taking tax free cash from any protected rights
benefits as many people have contracted out of SERPS of S2P.
Previous to A-Day, it would not be possible to take a tax
free lump sum from protected rights and this would have the
effect of reducing the tax free cash on the whole fund to
less than 25%.
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Protected rights
Protected right benefits can be treated as non-protected rights from 6 April 2012 and taken from the age of 55.
As
a result of the Pension
Simplification rules from 6 April 2005, one year earlier
than A-Day, part of a personal pension fund could contain protected rights
benefits that could be taken as income from the age of 50.
The protected rights are ring-fenced when they are received
by the pension provider from the Department of Social Security
(DSS). They represent rebated payments to a contracted out
state earnings related pension scheme (SERPS) and previous
to A-Day it was not possible to take a tax free lump sum form
these funds at retirement age. SERPS has now been replaced
by the state second pension (S2P) that can be contracted out
of protected rights.
Since A-Day on 6 April 2006 the income from the protected
rights portion can be taken as a 25% tax free lump sum and
the remainder treated as non-protected rights and used to purchase an annuity. Retirement
age limits applying from 6 April 2010 have raised the age
protected rights can be taken to 55. Furthermore, the annuities purchased with protected rights does not need to increase
each year when it is paid.
Previous to A-Day, protected rights benefits were treated
in a different way from the non-protected rights part of the
pension fund. Government rules relating to SERPS earned before
6 April 1997 had to provide an annuity income with a fixed
rate escalation of 3% per year.
It also provide on the death of the annuitant a compulsory survivors
pension for a husband or wife. This must be 50% of the
protected rights income even if the annuitant has no spouse
or defendants at the time of retirement.
For SERPS rebates earned after 6 April 1997 the annuity income
had to increase by LPI
escalation although if the annuitant did not have a spouse,
a survivors pension was not compulsory.
Retirement annuity policy
Before the introduction of personal pensions from 1 July 1988,
retirement annuity policies (RAPs) allowed individuals to
save for retirement in a tax efficient manner. The tax free
lump sum from a RAPs is calculated in a very different way
than a personal pension.
Since A-Day from 6 April 2006, the complex method for calculating
the tax free lump sum has been replaced with a straight forward
25% of pension fund.
In the majority of cases this means that the tax free cash
they can expect at retirement will be higher. However, providers
are not obliged to pay the new maximum tax free cash sums,
and it is possible that some may retain the old basis within
the scheme rules provided it does not breach the new 25% limit.
Previous to A-Day, the maximum tax free cash from a RAPs could not
exceed three times the remaining pension at retirement date.
For the purpose maximising the remaining pension, assumptions
can be made in the calculation that do not reflect the actual
income taken as a pension annuity. Therefore to maximise
the tax free lump sum the highest possible annuity income
possible must be achieved.
This is a single life annuity with no guaranteed period payable
annually in arrears and with no escalation. The main factors
that influence the size of the tax free lump sum are the age
of the annuitant, sex and the interest rates at the time.
Therefore the older the annuitant and the interest rates,
the higher the tax free lump sum as a percentage of the pension
fund. The calculation assuming an annuity income of 8% for
a pension fund of £100,000 is as follows:
| |
remaining |
= |
pension
before tax free cash is taken |
| |
pension |
|
1 + (3 x
0.08) |
| |
|
|
|
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remaining |
= |
£100,000
x 0.08 |
| |
pension |
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1.24 |
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|
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remaining |
= |
£6,451 |
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pension |
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So the remaining pension is calculated as three times £6,451.
This is £19,353 or 19.35% of the pension fund. The figure
is less than the 25% tax free lump sum from a personal pension
and a RAPs would require 11.11% as an annuity income to take
higher tax free cash. This means the annuitant would need
to be over 70 years of age given the current rate of annuity
interest.
AVC & FSAVC
Some individuals would have made extra contributions to pension
planning due to a shortfall in their final
salary pension with their employer. This could have been
achieved through an additional
voluntary contribution (AVC) scheme provided by the employer
or through a free standing AVC (FSAVC) from an insurance company.
Since A-Day, the Pension Simplification rules introduced from
6 April 2006 allow a tax free lump sum of 25% to be taken
from an AVC or FSAVC. Previous to A-Day, the
purpose of an AVC and FSAVC was to provide additional pension income and therefore
it was not usually possible to take a tax free lump sum.
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About Sharing Pensions
Sharingpensions.co.uk was created by its founder Colin Thorburn in 2001 to provide a free pensions and annuity resource to hundreds of thousands of people at retirement making their decision making easier and to select the best options.
Colin Thorburn has nineteen years experience in pensions and annuities, is an individual authorised by the Financial Conduct Authority and business is submitted through Blackstone Moregate Ltd which is authorised and regulated by the FCA (no. 459051).
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| Single |
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55 |
£6,132 |
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|
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60 |
£6,532 |
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65 |
£7,247 |
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|
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70 |
£8,170 |
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| Joint |
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55 |
£5,784 |
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60 |
£6,234 |
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65 |
£6,808 |
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70 |
£7,616 |
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| £100,000 purchase, level and standard rates |
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