Taxation of a pension plan redemption

A poorly planned redemption could seriously reduce your life savings: learn about the applicable tax rules and avoid surprises

Taking out a pension plan is one of the best strategies to ensure your future. With just a nominal monthly contribution, you will not only be adding to your savings every month, you will also be reducing your taxation base for personal income tax (IRPF in Spanish), so you can pay lower taxes. However, when considering these benefits that you can take advantage of today while still working, you must also be thinking about the taxes you will have to pay when redeeming your pension plan later on. What kind of taxes are applied when your savings in a pension plan are paid back later?

"Redemption of a pension plan” refers to the process of getting back the money you have invested into your plan. Every contribution you make into a pension plan is deposited into a pension fund, where the money then being invested based upon the fund's investment policy. In general, this will generate additional returns or interest for the participants over time. However, when the time comes to redeem the plan later, there are some specific taxation conditions that you must also take into account.

The conditions for redeeming a pension plan are wide ranging. In addition to the most common example of regular retirement, redemption may also be possible in the case of disability, death, unemployment, serious illness, etc.

Upon redemption, we will receive a tax bill that will vary according to how you receive your pay-out: either in the form of periodic payments, or all at once as a single payment, or as a combination of these two.

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Redemption as periodic payments (income)

If you redeem in the form of income, you will receive the funds at regular intervals (usually monthly) at either a fixed or variable rate. This type of redemption must be declared on your annual tax return as part of your annual income. In other words, the money received from your pension plan must be added to any state pension funds you are receiving. Adding these two amounts will produce an annual income amount that will determine which personal income tax bracket you fall into, and you will then be taxed accordingly.

In 2017, for example, the taxation on income between €12,450 and €20,200 per year was 24%, and for the next stream (€20,200-€35,200) it was 30%. In other words, when you add the amount of your monthly pension plan payments into your total income, this can result in a higher tax rate, and not just for the first year but for the entire time period when you are receiving payments from your pension plan.

Redemption as a single payment

You can also choose to redeem your pension plan all at once. With this option, the entire amount you have contributed into the plan over time is paid back to you as a single payment. However, this will result in a substantially higher total income during a single tax year, which will greatly increase your income tax assessment base.

The result of receiving it in this way it a rise in withholdings according to taxable income. For higher amounts, it is important not to forget that all annual income over €60,000 is taxed at 45%. In other words, for the year during which you receive this single redemption payment, your income tax assessment base will be determined by adding the amount of this redemption to all of your other income received.

There is another point that should be noted here: this is a one-off payment, and it is not necessary to pay further tax on the pension plan in subsequent years, as is the case in the previous case: where redemption in the form of income will generate tax obligations during every year these payments are received.

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Mixed redemption

Finally, there is a third way to redeem your savings in a pension plan: hybrid redemption. With this method the amount you have saved is divided into two parts, with one part being paid out initially as a large payment and the rest as periodic income.

Regardless of how this amount is distributed, the taxation of the pension plan redemption is exactly the same as that set out in the previous examples: all of the payments must be declared on your annual tax return as earned income, and the tax applied is based upon the resulting taxable income base.

Given that the taxation upon redemption of a pension plan is an important issue, BBVA offers various tools and calculators to help you improve your knowledge of pension plans. You can make calculations and compare numbers with no commitment, and find out right away how you can make sure that your investment will really pay off in the future.

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