In our weekly series, readers can email in with any questions about retirement and pension savings to be answered by our expert, Rachel Vahey, head of public policy at investment platform AJ Bell. There is nothing she does not know about pensions. If you have a question for her, email us at money@theipaper.com.
Question: I want to buy a fixed term annuity. I have a large lump sum sat in a savings account and am thinking of putting that into a pension first before buying the annuity so I can get tax relief. What is the limit I can pay into the pension before I can buy the annuity?
Answer: There are two different types of annuity you can buy that can give you a regular payment for a fixed term – one direct from your own savings (a purchased life annuity) and one through a pension. Each has its own tax rules and tax advantages, so you need to compare the rules to see which works best for you.
A purchased life annuity is where you exchange a cash lump sum for a regular guaranteed income which is paid for a specified term or for the rest of your life.
Each purchased life annuity payment is made up partly of the return of your original lump sum – the capital amount – and partly of investment return. You won’t be taxed on the capital element, but the investment return element will be taxable as savings income.
Your second option is to pay your lump sum into your pension and then buy a fixed term pension annuity. You should automatically receive basic tax relief (at 20 per cent) added to your pension account.
If you are a higher rate taxpayer or an additional rate taxpayer, you can claim further tax relief from HMRC. You can do this easily either by including details in your self-assessment form (if you complete one) or by contacting HMRC online.
However, there are limits on how much you can pay into a pension and receive tax relief. The first is that you cannot pay in more, including tax relief, than your UK relevant earnings – these are broadly your employed or self-employed earnings. If you have no earnings, then you can only pay in £2,880, which is topped up by the tax relief to £3,600.
The second limit, the annual allowance, states that the total contribution from you and your employer, as well as tax relief, cannot exceed £60,000 a year. If you have unused annual allowance from the three previous tax years, you can carry that forward to this tax year and make a higher contribution (if you have the earnings to justify that).
However, if you have already flexibly accessed a pension – for example by taking income from drawdown – then your annual allowance is reduced to £10,000 a year. And if you have very high earnings, then it may also be reduced.
One other point to watch is the pension recycling rules, particularly if you have recently taken tax-free cash from a pension or plan to do so soon. These rules are designed to stop people paying tax-free cash back into a pension simply to gain extra tax relief.
HMRC will consider factors such as whether your pension contribution is significantly higher than in previous years and whether you intended to recycle the tax-free cash. From what you have said, that does not appear to be your intention, but it is still important to take care.
Once you have made the payment, you can immediately access your pension if you are 55 or over (rising to 57 from April 2028). You can take up to 25 per cent of the fund as tax-free cash, and then you can use the remainder to buy a fixed term annuity for a specified period. The pension annuity payments will then all be taxed as income.
For both fixed term options, you may be able to increase your income by a fixed percentage or link it to inflation. And you should be able to choose a death benefit option to avoid losing some
of your investment if you die soon after you start taking your income. The older you are, the more income you are likely to get, and if you have certain medical conditions or lifestyle choices, this may mean you get higher payments.
Both options offer different tax benefits – the purchased life annuity provides more tax-efficient regular payments; the pension annuity benefits from upfront tax relief. The right choice for you will depend on your personal circumstances.
Finally, a fixed-term annuity can provide a guaranteed income for a set period. For example, it could bridge the gap until your workplace or State Pension starts. It can also give you a secure income for a few years before you review your retirement plans, rather than locking you into the same rate for life.
But there are other investment options which may also help you meet your goals and could be better suited to your circumstances. You may want to speak to a financial adviser to help you decide which option is right for you.