Tax treatment of UK pension payments
Pension payments in the UK are, in most cases, taxed as earned income, and residents in Portugal who have pensions payable from the UK may find that they are taxed twice – once under the UK PAYE system and again in Portugal.
However, Portugal, in line with many other European countries, has a Double Taxation Agreement (DTA) with the UK whereby a resident of Portugal can take their pension in Portugal and reclaim the tax paid in the UK.
A simple way to avoid having to keep reclaiming overpaid UK tax is for the member to apply for a UK “NT” tax code which allows the UK scheme to make the payment without any tax deduction. The gross pension income can then be declared in Portugal in the usual way.
An alternative is to consider transferring your UK pension to a Qualifying Recognised Overseas Pension Scheme (QROPS). However, following recent significant changes, all pensions – including QROPS – now have important restrictions that make careful planning necessary.
What is a QROPS
If you have a UK Defined Contribution (DC) scheme (eg a SIPP or Personal Pension), the benefit payable on death to your beneficiaries is usually the value of your fund at the date of death.
If you have deferred benefits in a UK ‘defined benefit’ (DB) scheme (often referred to as a ‘final salary’ scheme), it is not possible for your family to receive the capital value of your pension on your death – a dependant’s pension is usually payable instead which is taxed as earned income.
It is possible to transfer either type of arrangement to a Qualifying Recognised Overseas Pension Scheme (QROPS) which is, as the name suggests, a non-UK pension arrangement. You retain much of the flexibility of a UK DC scheme but without the potential tax burden imposed by UK rules. All QROPS providers must certify to HMRC that their products meet HMRC requirements; failure to do so may result in an unauthorised payment tax charge being levied.
The advantages of a QROPS are very similar to those of a UK pension in that you can take income and cash as and when you need it, and the whole of your fund can be passed to nominated beneficiaries on your death. However, two key differences are that:
- Income from a QROPS is generally paid out gross without the need for a UK ‘NT’ code and
- Once transferred, the fund will generally not be subject to UK legislation – but see the comments below on recent changes following the October 2024 Budget.
UK Pension Taxation
The Lifetime Allowance (LTA) – the attraction of QROPS
For many years, a significant reason to transfer to a QROPS was the UK Lifetime Allowance (LTA) which imposed a limit of £1.73m on the total ‘tax-privileged’ amount you could hold in a UK pension fund.
Any fund in excess of this amount would be taxable at 25% (or possibly 55% if you took the excess amount as cash). A transfer to a QROPS removed any future liability to the LTA.
UK Death Benefits taxation
UK-resident beneficiaries of a UK pension fund can receive proceeds of a UK pension fund free of tax if the member dies before the age of 75. If the member dies after 75, benefits are taxable at the beneficiary’s marginal (highest) rate.
Many expats transferred their UK pensions to a QROPS to escape the LTA.
However, following the abolition of the LTA in April 2024, the Government introduced two new limits on UK pension funds.
1 Lump Sum Allowance (LSA)
The LSA is a maximum lump sum allowance (LSA) that can be drawn free of UK tax.
2 Lump Sum Death Benefit Allowance (LSDBA)
There is a maximum tax-free lump sum allowance payable on death of £1,073,100.
You may be entitled to a higher LSA and/or LSDBA if you have any form of pension protection.
The Overseas Tax Allowance (OTA)
Following the abolition of the LTA , the Government introduced an Overseas Transfer Allowance (OTA). This is 25% of the excess over £1.073m for any transfer from a UK scheme to a QROPS. A transfer to another UK arrangement – such as to a SIPP or another Personal Pension – is exempt.
For larger pension funds, this made a transfer to a QROPS less attractive.
The Overseas Tax Charge (OTC)
Another consideration is a transfer from a UK pension to a QROPS, will trigger an Overseas Tax Charge (OTC) of 25% of the value of the fund unless certain specific exemptions apply. The most common is where the member is resident in the same country as the one in which the QROPS is established – for example if the member lives in Malta and has a QROPS which is Malta-based, then the charge does not apply.
The October 2024 Budget removed a previously available exemption – where both the member and the QROPS are resident in an EU state (but not necessarily the same country). If the member is not resident in the same country as the one in which the QROPS is established, there will be a tax charge of 25% of the fund.
The introduction of the OTA and the amendment to the OTC exemptions have made transfers to a QROPS less attractive.
Inheritance Tax – October 2024 Budget
A major surprise in the October 2024 Budget was that, with effect from 6 April 2027, most unused pension funds and death benefits will be included within a person’s estate for IHT. This will have major impact on pension and estate planning.
The October 2024 Budget also introduced a ‘residence-based’ test for Inheritance Tax (IHT), replacing the ‘domicile’ basis that currently prevails. Broadly, if you have been non Long-Term Resident (non-LTR) in the UK for more than 10 years, your worldwide assets will not be subject to IHT; UK assets will still be included.
Is a QROPS suitable for me?
All these changes raise the issue of whether a transfer to a QROPS is still attractive for expats.
A QROPS may be suitable for you if:
- Your fund is likely to breach the new LSA or LSDBA limits
- You are near the new OTA limit or are likely to breach it in the future
- You are likely to be a non-Long Term Resident (non-LTR), in which case all of your worldwide assets – including your QROPS – will be exempt from UK IHT. However, you must weigh this possible exemption against any ‘estate duties’ that could be payable in your country of residence.
Example
If you die aged 75 or over and your pension is subject to IHT, and the beneficiaries are basic rate taxpayers living in the UK, the effective tax rate on the pension fund is 52%.
For a higher-rate taxpayer (40%), the effective rate is 64% and, for an additional rate taxpayer, (45%), it is 67%.
You should also bear in mind that if you are not resident in the same country as the one in which the QROPS is established, the OTC of 25% will apply.
Even if you are exempt from the OTC, you will still be liable to a tax charge of 25% on the excess over £1.073m.
This information is based on current legislation, which is subject to change. This does not constitute advice – you should seek qualified professional advice.
We are not tax advisers – you should seek independent tax opinion.
Please get in touch with us if you would like more information.