How is the 40% reduction applied to pension plans?

How the 40% reduction is applied when you redeem your pension plan contributions plus the interest

After years of hard work, you reach retirement and one of the first questions many new retirees ask themselves is how to redeem their pension plan or plans. Remember that you are not obliged to redeem a pension plan when you reach retirement. In fact, you can continue making contributions to it and still qualify for personal income tax exemption. You only need to take into account that once you begin to take money out of the plan, the contributions you make thereafter cannot be redeemed under the retirement contingency. Therefore, the first question to ask yourself is whether you really need to redeem your pension plan. Some people decide not to redeem their plan on retirement and leave it as an inheritance for their heirs, given the tax flexibility of the death contingency (it is not subject to Inheritance Tax and tax payments may be deferred to a future time chosen by the beneficiary). 

If you decide to redeem your plan, bear in mind that, as it is a sum that will be paid in your favor, you will have to pay tax on it. Therefore, it is important to be aware of the keys for declaring what you have obtained after retirement (or other contingencies) on redeeming your pension plan, in order to achieve the best possible fiscal advantages. In certain cases, it is possible to apply a 40% reduction to the amount redeemed and only declare the remaining 60% for tax purposes. How is this reduction applied?

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Pension plans have interesting tax benefits that make them an ideal savings product. Up to the time you redeem it, the contributions can be deducted from your personal income tax base. However, once you have redeemed it, the resulting amount is subject to tax. As specified in the Personal Income Tax Act 35/2006, for tax purposes the capital of a pension plan is treated as earned income, making it equivalent to the salary or unemployment benefit you receive during your working life. 

In this respect, therefore, we are speaking of earned income. In contrast to what happened when you made the contributions, the returns you receive do increase your personal income tax base and, therefore, the amount of tax you pay. Even so, there are different ways of achieving a somewhat more advantageous fiscal treatment that will depend mainly on how you choose to redeem the plan: 

  • As capital: The beneficiary receives the total amount of the plan in a single payment. It can be an immediate payment (on reaching the contingency), or deferred to a later date by the beneficiary. 
  • As income: The income can be of different types: temporary or lifetime, of a guaranteed amount and duration; or financial income whose amount or duration are not guaranteed, but depend on the evolution of the share and the return on the pension fund. The income may revert to other beneficiaries in the event of the death of the recipient. 
  • Mixed-form: Combine capital and income. 
  • As a withdrawal: The beneficiary freely chooses the dates and amounts of the withdrawals, without any set frequency. The amount pending payment also varies according to the evolution of the share in the fund and its return. 

Now, did you know that there is something known as “the 40% reduction” that will help you save on your tax payments?

The 40% reduction

Shares prior to 12/31/2006 that are received in the form of capital benefit from a reduction of 40%. In other words, you will only pay tax on 60% of the capital reimbursed in this way. To benefit from this, the plan must be redeemed within the term stipulated in the Act and will depend on the date when the causal event occurs: 

  • Contingencies occurring in or prior to 2010: the 40% reduction can be applied up to December 31, 2018. 
  • Contingencies occurring between 2011 and 2014: the reduction can be applied if the redemption takes place before the completion of the eighth year from the occurrence of the contingency. 
  • Contingencies occurring from January 1, 2015: the 40% reduction will apply if the plan is redeemed during the fiscal year in which the contingency takes place or in the following two. 

Even with this reduction, it is important not to forget that the obligation to pay tax on the remaining 60% is a good reason for adopting a suitable strategy for redeeming all the shares, given that redeeming a large amount in the form of capital can have a very high fiscal impact, despite the 40% reduction.

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Strategies for a more advantageous pension plan redemption

The BBVA pension calculator will help you calculate the capital you can obtain when you redeem the plan. Depending on the type of plan, your tax status, the contributions you have made, the date of the plan and the redemption date, you will be able to see the total you will receive from the fund, the tax saving you can benefit from and the amount of tax you will have to pay. This will make it a lot easier for you to plan the redemption and choose the best moment to do it.

There are several strategies you can use to improve your tax position using the 40% reduction. Given that this reduction is only possible when the redemption is in the form of capital, we advise you to choose a mixed redemption, separating the contributions made before and after January 1, 2007. In other words, redeeming as capital the benefits obtained from the contributions made before that date, and as income the funds generated by contributions made subsequent to 2007.

This way, you will be able to benefit from the 40% reduction for valid contributions prior to 2007, whereas it will be more beneficial to redeem the rest in the form of periodic income to lessen the tax impact. Taking into account that contributions made after January 1, 2007 cannot be included in the reduction, it is much more beneficial to withdraw this capital gradually. Otherwise, if you take it all at the same time, the tax burden will increase, and you will also be in a higher personal income tax band, meaning that you would pay a lot more tax.

It is equally important to consider the strategy you need to follow when you have several simultaneous pension plans. If you wish to take advantage of the 40% reduction, you will be able to do so with several plans, as it is applied once to each of them. Take note, however, that all plans must be redeemed in the same fiscal year. Otherwise, those carried out later will not count and the reduction would only apply in the first year.

Remember that our calculator will show you clearly the amounts you will receive from your capital and the tax you will have to pay.

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