Can a Pension Transfer Help Reduce My Tax Bills in Retirement?

I’m nearing retirement and have a few different pensions saved up from across my working life. I’ve read that a transfer could save me tax in retirement — how can this be true?

Question asked by Steve Harrington
30/09/2019

Tax on Pensions

When you receive payments from your pension(s), it’s added together with all other income you receive in a given tax year, including the State Pension and income from buy-to-let properties etc. to come to your total income for that tax year. The tax year runs from April to April.

In the 2019/20 tax year, you can receive £12,500 without having to pay any income tax. Above this, you start to pay income tax at 20% on all earnings between £12,501 and £50,000. Above this, you pay higher rate tax of 40%. There’s also an additional rate tax band, standing at 45%, for incomes in excess of £150,000.

You pay income tax on your pension just as you would have done on income from your job, as outlined above.

Tax on Final Salary Pensions

A defined benefit pension, sometimes known as a final salary pension or a career average pension, is a guaranteed income stream throughout retirement. It’s typically index-linked to keep pace with inflation. This means that, each tax year, you’ll be receiving a fixed income from your defined benefit pension scheme that you can’t adjust to meet changing circumstances.

Such circumstances might include needing more money one year to pay for a ‘big ticket’ item such as a round-the-world trip or a child’s wedding. Alternatively, you may find you need to take less income one tax year to keep you within a tax bracket, thereby reducing the amount of income tax due on your retirement income.

While final salary pensions are rightly seen as the gold-standard of pension saving because they promise to pay a guaranteed, inflation-proof income for the rest of your life (and typically after that for the rest of your spouse’s life), they don’t have the same amount of flexibility as a defined contribution pension does in terms of providing an adjustable income.

Tax on Defined Contribution Pensions

A defined contribution pension in drawdown, on the other hand, does provide this flexibility that allows you to dial up and down your pension income as and when required. This can indeed help you save tax by keeping you under certain tax brackets in any given tax year.

With drawdown, you withdraw income, lump sums or a mixture of the two from a drawdown fund that remains invested throughout your retirement. It’s up to you how much you take out and when, as opposed to a final salary scheme, where the funds are paid to you regularly regardless of want or need.

Another benefit of a defined contribution pension in drawdown is that it’s typically free from inheritance tax when the original pensioner dies and leaves the pension to a beneficiary. This is because a defined contribution pension fund is backed by the pot of money you’ve been saving into throughout your working life; if you die before you spend it all, it’s yours to leave to whoever you wish.

A final salary pension, not being a pot of money saved up and rather being a promise from an employer, doesn’t have such simple rules for inheriting a pension.

As mentioned, you can typically leave a pension to your spouse, which will continue to be taxed as income at their highest marginal rate. Other than that, there’s little scope for anyone else to inherit a defined benefit pension scheme, so the tax rules are more favourable when it comes to individuals inheriting defined contribution schemes.

While there are some advantages to a defined benefit pension transfer, it won’t be right for most people. You should discuss any potential final salary pension transfer with an adviser to check whether it’s the best course of action for your retirement. This is a mandatory legal requirement if your pension is worth more than £30,000.

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