You served your country for many years, and have risen through the ranks to achieve a reasonably ‘cushty’ guaranteed military pension (say £20,000). So good so far…
However, there is a catch 22 with your ‘transition’ to Civvy Street. Let’s say that your employment provides a good salary of say £35,000. It’s a bit less than that you achieved in service, but that’s OK, you have your pension to fall back on.
But hang on a minute; what’s all this tax I am paying? I hear you say.
Tax and the Armed Forces Pension
Well, because of your exemplary service you are entitled to take your pension and lump sum at a much earlier age than your new counterparts, but the income this provides pushes you above the Higher Rate Tax Threshold, currently £42,475, including your tax free personal allowance (£10,600).
That means that any income above this threshold will be charged tax at 40%. What is more, because all of this income is taxable at 20% or 40%, you find that the income you receive is being taxed at a marginal rate of 27.15%.
The amount of income that is being charged at 40% in this case is £12,525, resulting in tax of £5,010 being paid – or 25% of your pension!
Pension Solution
The easiest solution is to use the pension rules to your advantage. Any amount you pay into a pension receives tax relief at the highest rate you pay. So if you are paying higher rate tax, you would get the 40% tax paid on that income back from HMRC, the first 20% being paid into your pension and the rest reducing the tax you pay through self-assessment.
That means, in this case by paying £12,525 each year, or £1,044 pm into a pension, all basic and higher rate tax would be mitigated. However, you pay only £835 (10,020p.a.) into the pension, HMRC pay the £209 and you pay £209 less tax at the year end.
The pension would grow free of tax and without any growth and ignoring charges; you will have built a fund of more than £60,000 over five years.
The new rules say you can take your benefits at 55, living off the fund rather than buying an annuity – Flexible Access Drawdown. This means that if you prefer not to buy an annuity, you can leave your fund invested and take a draw from it monthly, annually or on an ‘ad hoc’ basis.
The first 25% of the fund is ‘tax free’, with the remaining ‘pot’ being taxable at your highest rate. Even when you add in the state pension (at 66/67 for many), it is likely that most ‘formers’ will be basic rate taxpayers and so this solution is a great tax benefit.
Lastly, in the event of your death, your spouse or beneficiary can have the fund; tax free for your spouse, taxable for your other beneficiaries. If there is any fund left on your wife’s death, she can pass it on too.