DB pension and tax implications

twoLou

My husband is 60 this year and has​ the​ two small ​DB​ pensions​ shown below​ that are due to start paying out this summer.

He will continue to work for another 6 years after these start paying out and is a higher rate tax payer and it’s the tax implications​ in these years​ that are leaving him undecided in which is the best option.

He was going to take the higher monthly ​payments​ but now isn’t so sure​.

We would be grateful for others with more knowledge to give an opinion

Pension 1 - £3204.48 year or £267.04 month

                    Lump sum offered £16310.41

                    Reduced pension if above taken

                    £2446.68 year or £203.89 month

Pension 2 -£2987.11 year or £248.92 month

                    Lump sum offered £14103.13

                    Reduced pension if above taken

                    £2115.47 year or £176.28

He will have another ​DB​ pension of a similar size in 5 years, a ​DC ​pension when he reaches 66 and​ has checked with HMRC and​ will receive the full state pension.

​

Many thanks in advance​

MarkCarnage

A number of factors to consider here:
- Is the commutation factor attractive enough to warrant taking the lump sum after taking account of 6 years of higher rate tax on the pension? The first one looks more attractive than the second one, but may have better inflation escalation for the pension. 
- Would he need the extra amount once he fully retires? Difference appears to be about £135 a month gross, about £1500 a year. Only you can answer that one. You haven't quantified the DC pension. Sounds like he would have about £17,000 a year gross including State Pension but excluding whatever the DC might produce - could be £1k could be £20k, we have no way of telling from the above. 
- Do you need the lump sum for anything now? 

twoLou

Thank you for taking a look.
From all the reading we’ve done on DB pensions the advice always seems to be that is is better to forego the lump sum in favour of the higher pension. However this sound advice doesn’t take into account having to lose so much of it to tax for 6 years and that is the quandary.

We have a small mortgage that we could put the lump sum towards paying off but likewise the monthly pension payments would be used to overpay the mortgage which would clear it by the time my husband retires, therefore the lump sum is not really needed.

I don’t think we’d need the extra pension when my husband retires but who knows?

HappyHarry

He could contribute the pension received into a personal pension for the next six years, and claim the tax relief. Then, come final retirement, he has the maximum pension still as well as a second pot of tax-efficient funds to draw on.

MarkCarnage

From all the reading we’ve done on DB pensions the advice always seems to be that is is better to forego the lump sum in favour of the higher pension. However this sound advice doesn’t take into account having to lose so much of it to tax for 6 years and that is the quandary.

I don't think that the advice is always to do that. Depends on a lot of things, including the commutation rate, the inflation escalation of the pension, your tax situation, immediate spending needs, and your health.

I took the maximum TFLS out my DB scheme, partly because it was half funded by my AVC fund, partly because I had some quite significant capital spend envisaged over next couple of years, and partly because if I hadn't, I would now be in higher tax band in Scotland, as it kicks in about £6k lower than in England and at a higher rate too. The commutation factor was pretty good too, so it was quite an easy decision for me to take it. 

DairyQueen

Has he checked whether a late retirement factor is applied if he delays taking either/both DBs? Some schemes offer a generous increase for each year of delay whilst others offer zero.

Mr DQ has delayed taking his DB for the following reasons:
- we don't need the income yet
- his scheme applies a generous late retirement factor
- he pays HRT
- he can't 'recycle' any DB pensions in payment per HappyHarry's post as he has LTA protection and further contributions are now forbidden.

If you don't need the income but the late retirement factor is miserly then I would consider HappyHarry's suggestion. The pensions in payment would be taxed at HRT but your OH would be able to recover all of the tax paid by contributing the net amount received into a PP or SIPP.  Tax relief at 20% would be claimed by the pension provider and added to the pension and your OH would claim the remaining 20% via self-assessment.

The net effect being that the DB payment is received tax free. He will then have another (flexible) pension pot that can be accessed at any time. 25% of this will be tax-free and the balance will be paid at his highest marginal rate at the point that it's withdrawn.

There are various ways that this pot could be accessed to minimise the tax paid. For example, he could opt to take 25% tax free on each withdrawal rather than 25% of the whole pot up-front. If (for example) he opted to retire before other DB and SP begins, and he had no other income in any tax year, he could take up to £16,000-ish from this pot without paying any tax.

This separate pot can also be left free of IHT to his beneficiaries.

Dazed_and_C0nfused

DairyQueen said:

Has he checked whether a late retirement factor is applied if he delays taking either/both DBs? Some schemes offer a generous increase for each year of delay whilst others offer zero.

Mr DQ has delayed taking his DB for the following reasons:
- we don't need the income yet
- his scheme applies a generous late retirement factor
- he pays HRT
- he can't 'recycle' any DB pensions in payment per HappyHarry's post as he has LTA protection and further contributions are now forbidden.

If you don't need the income but the late retirement factor is miserly then I would consider HappyHarry's suggestion. The pensions in payment would be taxed at HRT but your OH would be able to recover all of the tax paid by contributing the net amount received into a PP or SIPP.  Tax relief at 20% would be claimed by the pension provider and added to the pension and your OH would claim the remaining 20% via self-assessment.

The net effect being that the DB payment is received tax free. He will then have another (flexible) pension pot that can be accessed at any time. 25% of this will be tax-free and the balance will be paid at his highest marginal rate at the point that it's withdrawn.

There are various ways that this pot could be accessed to minimise the tax paid. For example, he could opt to take 25% tax free on each withdrawal rather than 25% of the whole pot up-front. If (for example) he opted to retire before other DB and SP begins, and he had no other income in any tax year, he could take up to £16,000-ish from this pot without paying any tax.

This separate pot can also be left free of IHT to his beneficiaries.

Tax relief on pension contributions doesn't achieve that outcome.

Round sum figures used for simplicity.

Gross pension income £6k taxed at 40% = £3,600 net income received.

£3,600 paid into a SIPP or other relief at source pension is grossed up to £4,500.

Basic rate band is increased by £4,500 making an extra £4,500 income taxable at 20% instead of 40% so possible tax savings of £900.

End result is the £6,000 pension has become £5,400 (pension fund of £4,500 plus tax saving of £900).

In niche circumstances the tax saving could be significantly higher but for most it will be a maximum of 20%, assuming sufficient higher rate tax had been paid in the first place.

DairyQueen

Dazed_and_C0nfused said:
Tax relief on pension contributions doesn't achieve that outcome.

Round sum figures used for simplicity.

Gross pension income £6k taxed at 40% = £3,600 net income received.

£3,600 paid into a SIPP or other relief at source pension is grossed up to £4,500.

Basic rate band is increased by £4,500 making an extra £4,500 income taxable at 20% instead of 40% so possible tax savings of £900.

End result is the £6,000 pension has become £5,400 (pension fund of £4,500 plus tax saving of £900).

In niche circumstances the tax saving could be significantly higher but for most it will be a maximum of 20%, assuming sufficient higher rate tax had been paid in the first place.

I agree with the highlighted statement and am happy to be corrected but I am struggling with the statement 'BRT band has increased by 4,500'. Perhaps it's semantics.

Of the £2,400 tax paid on the £6k pension, £900 will be returned via tax relief on the pension and an additional £900 via self-assessment. So, yes, agreed that £600 of tax paid is unrecoverable in the tax year of contribution using this method.

So, let's say (and assuming circumstances allow) max TFC is withdrawn after the relief is added (£1,125) and this (plus the additional £900 returned via self assessment) is added to spouse's pension. The spousal contribution of £2025 will also receive tax relief at 20% so an additional £506.25 will be added making a total of £2531.25 in her pot.

Outcome = £3375 in his pot and £2531.25 in her pot. Total of £5906.25. Total tax paid from that £6000 pension payment= £93.75.

His pot will be crystallised so all further withdrawals will be taxable but she will be able to take at least 25% from her pot tax free. If they are able to time withdrawals such that they can withdraw in year/s when other income is limited then they will also avoid tax on the balance. Alternatively, they could ring fence both pots for inheritance and pass on to heirs tax free. 

May be an option for OP. 

Dazed_and_C0nfused

BRT band has increased by 4,500

That is how relief at source contributions work for personal tax purposes.

There is no such thing as an "extra 20%".  The gross contribution just increases the amount of the basic rate tax band.  So in very simplistic terms without any other complications the basic rate band is increased from £37,500 to £42,000.

£42,000 x 20% = £8,400 tax due instead of £9,300 (£37,500 x 20% (£7,500) plus £4,500 x 40% (£1,800)) = Personal tax saving of £900.

Adding money to the spouses pension could well being further benefits.  But adding the personal tax saving of £900 to the ops pension would also bring further benefits, even if only the 25% initial uplift.  We could go on and on, all I was trying to get across was that you cannot get all the 40% tax back by putting the net amount back into a pension.

DT2001

Does this work to utilise the maximum HRT?
Gross pay £6k, net £3.6k
Put £4.8k into pension and get £1.2k relief
BRT band increased by £6k meaning tax due reduced by £1.2k
You have to fund the £1.2k difference but maybe HMRC would adjust tax code if making monthly payments within the tax year.

better option is salary sacrifice as reduces NI.

This will be a case for a spreadsheet however we do not know all the information e.g.can the pension payments be ‘recycled’, will the OP have income to utilise all of the personal tax allowance etc