Pension plan tax deduction

One advantage offered by a pension plan is the tax benefits available in relation to the contributions you make

A tax deduction is a reduction in the taxpayer's taxable income, i.e. the amount that they have to include on their tax return to calculate the amount of tax they have to pay. One of the specific advantages offered by a pension plan is the ability to deduct the contributions you make from your taxable income, to lower the amount of the personal income taxes you must pay. But how does this tax deduction offered by a pension plan really work?

In order to answer this question you must keep in mind two fundamental aspects. The first is that deductions apply only so long as contributions are being made: when you eventually get this money back through redemption, the amounts you receive will be taxed as income. The second is that there are some legal limits to contributions.

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Limits on contributions into a pension plan

The annual contributions to a pension plan are subtracted from declared income that is used to calculate personal income tax. For example, if a person has a salary of €25,000 per annum and pays €4,000 into their pension plan, their income tax will be calculated as if they had only earned €21,000. As already mentioned above, there are some maximum annual amounts that you are allowed to deposit into a pension plan.

Up until 2014 these maximum contributions varied depending on the age of the plan's participant, However, following the tax reform of 2015, the amount for all age ranges was fixed at €8,000 per annum. However, there are series of exceptions that may allow you to contribute more, and you should be aware of these since the more you contribute to your plan, the higher the tax deduction you can apply.

Those whose spouse does not have income from work or who receives an annual salary of less than €8,000 can make contributions to their spouse's pension plan in addition to their own, up to €2,500 per annum.

Furthermore, for persons with disabilities (understood as those who have a physical or psychiatric disability equal to or greater than 65%), the maximum limit for pension plan contributions is established at €24,250. Other people can also make contributions into their plans for an amount up to €10,000, as long as the sum of all contributions does not exceed the cited amount of €24,250.

How the tax deduction for pension plan contributions works

As we have been saying, the tax deduction comes from the annual contributions made to the plan. You must take into account that this is not a typical deduction like the one you may get when you buy a home; it is a direct reduction made to the amount of taxable income you must declare on your annual tax return. This means that the money you contribute to your plan is subtracted from the total amount of income used for calculating how much income tax (IRPF) you must pay each year. When this taxable income goes down, the amount you will owe in taxes does too.

The clearest way of understanding how the deduction of a pension plan works is by looking at a practical example. Imagine that a taxpayer earned €40,000 last year and contributed €6,000 into her pension plan. Before deducting the contributions made into the plan, her taxable income would be €40,000, and she would have to pay personal income tax using the 37% tax bracket. However, since she made contributions, her taxable income would be reduced to €34,000, which means that her personal income tax would be calculated using the lower 30% tax bracket. In other words, not only do these contributions reduce the total amount on which the tax percentage is applied, but sometimes the deduction allowed for a pension plan can put a taxpayer into a lower personal income tax bracket.

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The tax relief, akin to the contributions, also has a limit established by law. This is the lesser of the following amounts: €8,000 or 30% of your net income from working and other economic activities. However, if you exceed this deduction limit you can transfer any excess amount to your personal income tax returns submitted during the next 5 tax years.

If you have any queries about the tax deduction of your pension plan, visit bbva.es for a free tool to help you to calculate how much tax you will save through your contributions. All you need to do is enter the amount of your annual contributions and indicate the personal income tax bracket that applies to you. This will help clear up any uncertainties.

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