Tax Treatment Of Pension Benefits

Before 6th April, 2006 the way benefits from a pension scheme could be taken and when it could be taken depended on the type of scheme in question. Now these rules have all been replaced by a single set of rules. A registered pension scheme can pay benefits as pension income on retirement and on death, as well as pay a cash lump sum on retirement or on death. Differences exist, however, in the tax treatment of cash lump sum payments and income payments.

One could not take benefits as at 5th April, 2006 whilst still working; also the benefit could only be taken at the pension scheme's normal retirement age. From 'A' Day a member of a pension scheme can start taking benefits from age 50 up to 75, and doesn't have to stop working to do this, as long as the scheme's rules permit. This age is known as the 'minimum normal pension age'. It will rise to 55 by 6th April, 2010. In spite of these changes, members with pension contracts before 'A' Day that permitted them to take benefits at an age lower than 50 or 55 (by 2010), can continue to enjoy this specialised normal retirement age, so long as the contract was set up before 10th December, 2003. Footballers and deep sea divers had such contracts. The benefit will however be tested against lifetime allowance, which will be reduced by 2.5% for every year that the normal retirement age falls short of age 50 or 55 (after year 2010).

On retirement up to 25% of the benefit accrued can be paid as tax-free lump sum. The actual amount paid will be based on scheme rules. Before 'A' Day most pension schemes paid less than 25% as tax-free cash lump sum, and this may still continue in some schemes. Cash lump sum that is in excess of the lifetime allowance will albeit incur a tax charge of 55%.

Benefit income at retirement can be taken in three main forms: secured pension, unsecured pension and alternative secured pension. With scheme pension income is securely paid for life from scheme assets. It may also be in the form of an annuity purchased with scheme assets to provide income for life. There is as well the option of a lifetime annuity which gives the member an opportunity to choose his/her own provider to pay the income, if a higher rate can be obtained. Scheme pension is the only method of income payment at the disposal of defined benefit schemes. It can also be offered by a money purchase scheme but not without first offering the member an option of purchased life annuity.
Pension income received under a scheme pension will be taxed as the pensioner's income through the PAYE system.

Unsecured pension is the method of pension income payment available to a member of a money purchase scheme, aged up to 75. It permits a withdrawal up to a certain amount directly from the scheme. Income received this way is taxed as the member's income via the PAYE system. Alternative secure pension is the only income withdrawal option for those older than 75. It is taxed in a similar way to income received under unsecured pension.

Income can be paid to the dependants of a deceased member, whether or not benefits were crystallised before death. The income paid will not be tested against the lifetime allowance, but will be taxed as earned income through PAYE.

On the death of a member, income as well as a cash lump sum or a combination of the two can be paid to the dependants of the deceased. The way the cash lump sum is taxed depends on whether or not benefits were taken before the member died. No tax will be charged on a cash lump sum paid, if the member died before the crystallisation of benefits. If the member had only taken cash lump sum before death then any cash lump sum paid will attract a tax charge of 35%. Also note that any cash lump sum paid will be tested against the lifetime allowance.

If the member died before age 75 whilst taking benefits, then a cash lump sum can only be paid if a 'protected annuity contract' was entered into before the benefit crystallisation began. The amount paid will be equivalent to the difference between the amount used to buy the annuity and the total of the gross income payments received up to the point of death. The cash lump sum will be subject to a tax charge of 35%. According to scheme rules it may be possible, for the dependant of the deceased to choose in which form the benefit should be paid.

It is possible for a member of a pension scheme from the age of 60 to 75 to have all benefits paid as a cash lump sum in so far as the value of the benefit is less than 1% of the lifetime allowance. Thus in the tax year 2008/2009 with a lifetime allowance of 1.65 million, if the value of the benefit is less than 16,500, the whole amount can be received as a cash lump sum. Up to 25% of this amount will be free of tax, but the remainder will be taxed as earned income via PAYE. Note that if the payment is from a number of schemes all payments will have to be carried out within a span of 12 months. A commutation of benefits can also occur if a member is seriously ill. This cash lump sum can only be taken in full up to age 74.

Membership of a pension scheme for a period of two years or more provides a right to 'preserved pension' if the member leaves the scheme. A membership for less than 2 years may confer the ability to obtain a refund of contributions; but this is not obligatory. If a refund is given, the first 10,800 will be taxed at 20% and the rest will be taxed at 40%. A transfer value should be provided for a membership of at least three months.

A knowledge of the tax treatment of pension benefits is necessary for retirement planning. It can help to get rid of false hopes about money that will be received at retirement or at death. Reality will be the fulcrum of the retirement plan, and a better financial future will be the long-term result.

I have a BA Hons. degree in Accounting and Finance. I am currently specialising in Financial planning.

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