What is the best way to redeem your pension plan?

One of the key moments in your pension plan investment comes when it’s time to get your money back.

Unlike other products with more limited taxation, you have several options when it comes to withdrawing your pension plan, and not all of them work in the same way. Depending on which one you choose, you will pay more tax or less, which is why it is important to analyze your options carefully. In fact, if you make the wrong choice, you could end up paying almost half of that money to the tax authorities.

How can you withdraw money from your pension plan?

Money from pension plans is always taxed as earned income, which is added to the general taxable income. In other words, the capital you get back will be added to your state pension or salary and taxed at the general personal income tax rates, which are as follows:

This taxation varies from that of most investment products, which are taxed as savings income and at different rates.

 With this in mind, pension plans can be redeemed in three different ways:

• In the form of capital, whereby you receive all the money accumulated in the plan in a single payment.
• In the form of an annuity, in which the money is collected periodically over time. The most typical way is to receive an annual, half-yearly, quarterly or monthly amount in the form of periodic annuities, although there are other models, such as life annuities.
• In a mixed form, which involves receiving a part in the form of capital and the rest in the form of an annuity. It is normal to recover this capital portion at the beginning of retirement.

Redemption in the form of capital or income has its own tax rules. In the case of a mixed withdrawal, the tax treatment will also be mixed: the capital part will be taxed as capital and the income part as income.

How is capital redemption taxed?

Basically in the way you have seen so far. In other words, the money from the plan will be added to your earned income and will be taxed at the general rate. In fact, for the tax authorities, it is just another source of income, like when you have two jobs.

The special feature of this formula is that a 40% reduction can be applied to amounts invested before 31 December, 2006.

However, this reduction can only be applied once and only if the plan is withdrawn within two years of retirement or the contingency that led to the withdrawal.

There is nothing better than an example to better understand how the 40% reduction and the plan’s redemption in the form of capital works. Let’s imagine that you accumulate 200,000 euros in your pension plan and that you are going to redeem it all at once. Let’s suppose that, of that capital, 70,000 euros correspond to contributions made before 2007.

What would the redemption figures look like? On the 70,000 euros prior to 2007, the 40% reduction can be applied, so that only 60% of that amount will be added when calculating your personal income tax.

That is 42,000 euros, which leaves the total amount withdrawn for tax purposes at 172,000 euros (130,000 + 42,000). That will be the money added to your state pension and salary to calculate how much tax you will pay on your pension plan.

Assuming that your pension is 18,000 euros (very close to the average), you would have a total taxable income of 190,000 euros. From this amount we need to subtract the personal and family minimum, which is 6,700 euros because you are over 65 years of age.

In total, and without taking into account other possible deductions, the tax base on which the personal income tax tables you have already seen will be applied will be 183,300 euros. So, when all is said and done, you will pay 73,386.50 euros in tax by withdrawing your pension plan as a lump sum.

What if we only take into account the taxes on the plan? In other words, we take the part of the taxes corresponding to the state pension out of the equation. In that case, you would pay only 71,239.50 euros for your savings (the difference is what you would have paid on your state pension).

The reason you will pay so much is that when you add up all the money in the plan, you will be taxed in the higher income tax brackets. Specifically, of the 183,300 euros, 123,300 euros will be taxed at the 45% rate. This means that 45% of that money will go to the tax authorities.

How is income from an annuity taxed?

If you choose to recover the plan as regular income, the money you receive year after year will also be added to the rest of your income (mainly your pension) when you pay personal income tax.

So, the more money you withdraw each year, the more tax you will pay, just as with your salary: a higher salary means a higher tax bill.

Again, an example may help you see this more clearly. Let’s take the 190,000 euros in the pension plan that you are now going to collect over 20 years (life expectancy in Spain is currently 83 years, which leaves about 15 years from retirement). This means collecting 9,500 euros from the pension plan per year.

With the figures we have seen above, the taxable base until the age of 75 will be 20,800 euros (18,000 from your state pension + 9,500 from your pension plan – 6,700 from your personal minimum) and 19,400 euros thereafter because the personal minimum increases by 1,400 euros.

In practical terms, this means that between the ages of 65 and 75 you will pay 4,405 in income tax. And the 10 years after that? The bill will be 4,030.55 euros. In total, you will have paid 84,355.5 euros in tax.

To get a clearer idea of how much of that tax is solely attributable to your pension plan, let’s once again remove the part of the personal income tax you would pay anyway on your state pension.

The difference in this case is enormous compared to the capital redemption: the tax bill for the plan alone amounts to 2,258.5 euros per year up to the age of 75. The rest corresponds to your state pension.

From the age of 75 onwards, the figure paid for the plan alone would be 2,152.5 euros. In total, if you were to withdraw it in the form of an annuity, you would pay 44,110 euros for the pension plan on its own. You would pay the rest of the tax bill, almost half, on your state pension.

What are the implications of each formula?

Beyond the numbers, each system for collecting money from your pension plan has a series of characteristics that need to be assessed. These are the differences and what to take into account in each case:

• Withdrawal in the form of annuities has a lower fiscal impact. In other words, you will pay less tax because personal income tax is progressive and, as you receive less each year, it is more difficult to reach the higher brackets.
• To recover the money in the form of capital and benefit from the 40% reduction, you must do so in the years after you retire. If you wait any longer, there will be no bonus and none of the money in the plan will be valid for a reduction.
• You cannot redeem the money in the form of several lump sums and keep applying the 40% reduction.

Is it better to get your money in the form of an annuity or a capital sum? A summary

The numbers favor income redemption over capital withdrawal, even taking into account the advantage of the 40% reduction on contributions prior to 2007.

Here is a summary using the example above.

Fortunately, life is not made up of black and white, but of shades of gray. In terms of your pension plan, this means that you can opt for a mixed withdrawal. This way you can receive money when you retire and apply the 40% reduction without your tax bill going through the roof.

 Whichever formula you choose, there are a few tips to help you pay less tax on your pension plan:

• Avoid withdrawing from the plan in the year you retire. Normally, your salary will be higher than your state pension, which means that you will pay more tax on the extra income from the pension plan. Remember that you can redeem your plan whenever you want, it is not obligatory to do so as soon as you stop working.
• Crunch the numbers to find out if you will be required to file a tax return. Your state pension is like your salary, as is the money in the pension plan. For personal income tax purposes, it is a second source of income and if you receive more than 1,500 euros a year from your plan, you will be obliged to file a tax return.
• Fine-tune the taxes you will pay to avoid going over the income tax bracket. Before deciding how much you want to receive each year in the form of an annuity, check what your maximum personal income tax bracket is with your state pension. Then calculate how much you can take from the plan to avoid going into the next bracket.

In the end, a pension plan is a tool for planning your retirement from which you will get a double return. On the one hand, the return you get from the plan thanks to your investments and compound interest and, on the other hand, the tax yield from the difference between the tax you do not pay on your contributions and the tax you pay on redemption.

There are, of course, alternative ways to save and invest, but the most important thing is that you are clear about how much you will actually need to have the retirement you want. That should be your starting point.