Pay under 5% tax on a pension over £1 million.

The government has tried to stop people from building up a pension worth over £1 million.

To do this they’ve introduced penalties of up to 55% for anyone who breaches the £1,073,100 lifetime pension limit.

However, there are ways to reduce these charges, which mean you could be paying tax well below the basic rate.

How to pay under 5% tax on a pension?

The lifetime pension allowance of £1,073,100 is frozen until at least April 2026.

This limit is applied to the total of all your pensions excluding your state pension. You can usually withdraw 25% tax-free and then the rest is taxed as normal income.

For lump sums above the £1,073,100 cap, a tax of 55% applies, and any amount beyond your lifetime allowance is charged at 25% on top of income tax.

The lifetime limit only applies at certain points of your life. One is when you take your pension, and the other is either when you reach 75 or when you die.

If you are 60 and have £1.3 million in a pension, then you would breach the limit. However, if you take £300,000 you will avoid the charge.

To do this you could move money into a Flexi-access drawdown product, which lets you withdraw the money like you would from your bank account. As long you don’t take income from this then you won’t pay any tax on it.

If you put £500,000 in this drawdown pot, you could take a 25% tax-free lump sum of £125,000, leaving £375,000. You will use up however much of the lifetime allowance that you transfer. If you transfer £500,000, then you use £500,000 of your allowance.

You could take a tax-free amount later, by transferring another part of your pension and taking 25% as a tax-free lump sum. For example, if you move a further £400,000 and take £100,000 as a lump sum.

The lifetime allowance has been reduced by £900,000, and you’ve taken out £225,000 tax-free. You will also have £675,000 in the drawdown pot.

The pension amounts will usually rise, and the rate at which it increases depends on how it’s invested. If we say the pension pot has increased by £30,000, which is not an unreasonable amount, there would then be £430,000 in the original pension.

Using the amounts above, you will have a total of £1,105,000 in the drawdown pot and the original pension combined.

What Happens to my pension when i’m 75?

Assuming no other money was taken out when you reach 75 years of age, the lifetime allowance remaining would be £173,100.

This is the point when the second calculation is done. 

As you have £430,000 in the original pension, this is £256,900 above the remaining lifetime allowance.

Whilst your money has been in your pension pot it will have been growing. The tax on this would be charged at 25%, assuming you take it as income. This would be a total tax bill of £64,225. This will usually be taken out directly by the pension company.

At this point, a total of £64,225 tax has been paid on a pension pot of £1.3 million, which is an effective tax rate of 4.94%, which is significantly lower than income tax.

The pension would not be subject to any further lifetime allowance tax charges after age 75, and you can either keep the money invested or take it as income which will be taxed at your normal income tax rate.

Leaving the money invested can help to reduce the Inheritance Tax (IHT). If when inherited, the beneficiary takes the lump sum, then this would count as income, and they would be charged as high as 45% on it. Plus, even after paying income tax, it would still form part of the estate, and therefore would be subject to IHT.

If the beneficiary left the money invested, they would only pay the income tax on whatever they withdraw. If a grandchild has no income, then they could withdraw £12,570 tax-free from the pot as this would use up their personal allowance.

The beneficiaries can name their own beneficiaries who could inherit these pension pots when they die, and if they die before the age of 75 then the pot would be available tax-free. If they died after 75, then the pot would be taxed in the same way as previously described.

Free money with your pension

Kind regards Ilyas