How to redeem a pension plan in the most profitable manner

Everything you need to know about redeeming your pension plan

A pension plan is an investment and savings product that is subject to two taxation processes, depending upon the phase of the plan we are in.

While you're paying into it, a pension plan helps you save. The capital directly invested into the plan will be deductable from your personal income tax (IRPF) assessment base, with a limit that will be the lesser of the following amounts: €8,000 or 30% of net income from work and economic activities. As a result direct, you will pay fewer taxes and you may even drop into a lower withholding bracket, which will result in even greater savings.

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For example, if during your period as a worker your yearly gross salary is €22,000, your personal income band will be 30%. However, if you decide to open a pension plan and contribute €2,000 a year to it, this amount will be deducted directly from your tax assessment base, which will then be €20,000. This will have put you into a lower bracket, and now you will be paying 24% tax on your income.

Income tax brackets in 2018

  • Between 0 and 12,450€ yearly = 19% of retention. 
  • Between 12,450 and 20,200€ yearly = 24% of retention. 
  • 20,200 to 35,200€ yearly = 30% of retention. 
  • Between 35,200 and 60,000€ yearly = 37% of retention. 
  • Of 60,000€ yearly hereinafter = 45% of retention.

 

What happens when the time comes to redeem the plan?

Beginning at the time of retirement (which is one of the contingencies that allows the plan to be redeemed), it will be possible to request redemption. Unlike during the years when contributions to the plan were being made, now the income you receive will increase your IPRF personal income taxable base, since the amount coming from the plan will be considered as earned income. To minimize the tax bill at the time of redemption, it is important to optimize the manner in which it is done.

Going back to our previous example, after contributing for 35 years with a yearly gross wage that in the last decade has been €22,000, you will have an approximate yearly pension of €19,615. According to the table of IRPF personal income tax brackets, your retirement income would be taxed at 19% (first 12,450 euros) and at 24% between 12,450 euros and 19,615 euros.

Once you have decided to redeem your pension plan, you will have different ways of doing so:

- Redemption as capital:

This modality would allow you to recover 100% of the capital accumulated in the pension plan, both the contributions you have been saving up over the years and the possible returns that have been derived from them.

If the pension plan is redeemed this way, you will have to make a single tax payment on the amount saved in your pension plan. To calculate it, you will have to add your yearly public pension of €19,615 and the marginal rate will have increased to a maximum of 45%. Anything above 60,000 euros (49,615 euros in this case) will be taxed at this maximum rate of 45%. The remaining amount from the plan (the part between 35,200 and 60,000 euros) will also be taxed at a higher rate: 37%.

In successive years you will return to only being taxed for the public pension if you do not receive other income, and the marginal rate will be reduced again. However, the tax impact in the redemption year is very high.

Cases where it is possible to receive a pension higher than the established limit

- Redemption as income:

Under these conditions, you will receive a fixed or variable amount of money on a monthly, quarterly, six-monthly or annual basis. This will depend upon the type of income you have chosen:

- Guaranteed annuities. Since the returns of a pension plan are subject to changes in the market, the payments you receive can vary over time. With a guaranteed annuity pension this does not occur, and you will always receive the same amount.

- Financial income. In this modality the amount that you periodically receive will vary depending upon the returns from the pension plan.

Returning to our example, in which you were receiving a state pension of €19,615 and you had managed to save €110,000 in your pension plan. However, this time imagine you have decided to redeem it in the guaranteed annuity modality, with a term of 20 years. In this way, your pension plan will give you approximately €6,569 a year that,  added to your public pension gives you a total of €26,184 which will be taxed as follows:

  • First 12,450 euros at 19%.
  • Between 12,450 and 20,200 euros, at 24%.
  • The rest, up to 26,184 euros at 30%.

Redemption in the form of income has a more gradual tax impact because the taxation is distributed across various financial years. It is usually the most efficient way of redeeming a pension plan, although you must plan the redemption correctly in order to determine which annual amount minimizes the tax bill and to try to avoid passing into the higher IPRF personal income tax bracket.

- Mixed redemption:

Mixed redemption is a third way of redeeming your pension plan. It consists of receiving a part of what you have saved as capital, and then receiving the rest as periodic income later.

Again, it is important to calculate the point up to which you would be interested in receiving a portion in capital, and therefore facing an increase – or not – in your personal income tax bracket.

This type of redemption may be an interesting option under the following circumstances.

To be taken into account: Law 35/2006

Law 35/2006 on personal income taxes establishes a transitional system whereby you can apply a 40% reduction when redeeming amounts from 12/31/2006 or earlier, provided they are received as capital within the period provided for by law. In this way, you will only pay tax on 60% of that capital. The amount remaining in your pension plan can be redeemed in the form of periodic income, with the corresponding increase in your IRPF income tax assessment.
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General advice for redeeming a pension plan

With all this information in hand, here are some tips that anyone who wants to save when redeeming their pension plan should know:

- Since the capital or income from the pension plan increases your taxable base for personal income tax (IRPF), it may be advisable to wait for redemption until the year following your retirement. The taxable base assessment will be lower when the income sources are lower.

- Carefully calculate the income that you want to receive on a monthly basis (or else during the period you have chosen). Is important not to go over the amount that will put you into a higher IRPF tax bracket with a higher tax rate.

- For pension plans with ‘low’ funds, it may be more attractive to redeem 100% of the capital and confront payment the corresponding taxes all at one time.

At BBVA we have pension plan calculators, which you can use to simulate how much you will receive when you retire, as well as how much taxes you will have to pay on those amounts.

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