What type of taxation is applied when redeeming a pension plan

The funds received are considered as earned income and are added to the taxable income base for personal income tax (IRPF in Spanish)

A pension plan is a long-term savings instrument with two types of different taxation. On one hand, there is the taxation corresponding to the contributions made into the plan, which provides tax advantages. On the other hand, there is the taxation applied when redeeming the pension plan, which is a different matter.

In theory, a pension plan is quite simple. The participant in the plan makes some contributions every year. In addition to increasing the amount saved in the pension plan, these funds will be invested according to the pension plan's investment policy and this will generate returns. Once the permissible time established in the policy has arrived, the participant can redeem the funds, or in other words, be paid back for the contributions made along with the interest earned. However, as is typically the case when it comes to taxes, it may be better not to do this all at once.

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Cases in which a pension plan can be redeemed

Although pension plans are designed to be a complement to retirement pensions, there are certain special circumstances in which beneficiaries can redeem the funds earlier:

  • Disability.
  • Death.
  • Long-term unemployment.
  • Severe illness.
  • To prevent eviction from a home.
  • Once 10 years have passed since the first contribution: this circumstance became valid in January 2015, and although further regulatory developments are pending, it has been established that any money contributed prior to this date can be redeemed beginning in the year 2025.

There is no single way to redeem a pension plan, and it is advisable to know them all because each one is taxed differently:

  • As a single payment: all of the funds are withdrawn at the same time.
  • As regular income payments: a certain amount is periodically paid out from the total funds existing. This frequency can be monthly, quarterly, half-yearly, or yearly.
  • Mixed: A portion of the funds is redeemed as a larger single payment, then the rest as periodic income.
  • As a special provision: in this case the funds are received at the request of the beneficiary, without a regular frequency and with the limitations established in the specific terms and conditions for the pension plan.

Taxation related to redemption of a pension plan

The taxation applied to redemption of a pension plan is basically the opposite process to that of contributions. When redemption of the pension plan occurs, the funds obtained are considered as earned income, which means that they are added to the taxable income base for personal income tax (IRPF in Spanish). This will in turn increase the amount of the taxes owed.

The current tax brackets for personal income tax in Spain are:

  • 0 to €12,450 = 19%
  • €12,451 to €20,200 = 24%
  • €20,201 to €35,200 = 30%
  • €35,201 to €60,000 = 37%
  • More than €60,001 = 45%

This is where the way in which redeeming the pension plan has an impact on its taxation. If you opt for redemption as a single payment, you will have to add this entire amount to the other income you have received during that same tax year. This will greatly increase the amount of taxable income used to calculate the personal income tax. For example, if a taxpayer declares other income of €25,000 and also decides to redeem a pension plan containing €80,000 as a single payment, this person's total taxable income will increase to €105,000. This will cause a shift from the 30% tax bracket into the highest bracket, which is taxed at 45%.

The hike in taxation caused by redeeming the plan at once means that the option of receiving it as income becomes interesting. Now suppose that the beneficiary of the same pension plan agrees to receive a €1,000 payment each month, withdrawn from the total amount available in the plan. This means that only €12,000 must be added each year to the total amount of taxable income.

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Transitional period for the 40% reduction

To finish off taxation of the redemption of a pension plan, let's focus on the 40% reduction in funds redeemed from the pension plan as capital. Although this reduction was eliminated in 2007, a transition period was also established that allows this reduction to be applied to the amounts contributed into the plan prior to January 1, 2007.

If the possibility of redeeming the pension plan occurs after January 1, 2015, the reduction can be applied in the same financial year as retirement or in the two following. For contingencies between 2011 and 2014, the reduction of the funds redeemed can be applied before the end of the eighth year from the contingency occurring. Finally, for cases occurring prior to the end of 2010, taxpayers can apply the 40% reduction to funds received until December 31, 2018.

To clear up any concerns you may have, at bbva.es you will find an extensive catalog of pension plans, where you will surely find one that is a good fit for your needs.

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