Retirement income tax in Spain
One of the most important decisions expats need to make when retiring to Spain is how to take pension benefits from their retirement plans. Pension legislation seems to be in a state of constant flux these days. Only by keeping on top of changes in tax and pensions regulations can one be confident of making the best choices for your personal situation.
A famous quote on taxation was uttered by George Sutherland, an English-born U.S. jurist and political figure: “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether to avoid them, by means which the law permits, cannot be doubted.” Few would contest the need for governments to raise taxes, but many would argue against the necessity to over-tax the population. As such, governments adopt the ‘stick’ of compulsory taxation for residents of a country, whilst also offering ‘carrots’ in the form of allowances and legal loopholes to soften the blow.
One such ‘carrot’ applies to the draw-down of pension income in Spain. For those who qualify, it is possible to take your pension as a ‘3-year temporary annuity’. The term ‘annuity’ refers to the original Latin root of the word meaning annual payment, which is not the same as taking a traditional insurance company annuity. This form of Spanish annuity allows an individual to withdraw equal amounts from his/her pension fund over a 3-year period.
Annuities are taxed favourably in Spain with the authorities treating a proportion of the income as non-taxable capital; only the balance is subject to income tax. The taxable income element of the annuity is determined by applying a fixed percentage of between 8 – 40% to the amount received, depending on the age of the beneficiary at the time the annuity vests.
QROPS holders qualify for this special tax treatment in Spain; the net effect of using this legal loophole is a pension income tax rate of between 3 – 5% per annum. An example may look like the following:
Case Study Example
A retiree aged between 60 and 65 with a QROPS fund worth €500,000 has an income requirement of €25,000 per annum for the first 3 years of his/her retirement. It is necessary to apply two separate tax rates to the gross income:
- Normal Spanish tax on lifetime annuities, which is banded according to age
- The special temporary annuity rate applied to foreign pensions, which is banded according to time.
Normal Spanish tax in this case on the lifetime annuity would be 24%. The retiree thus begins the calculation by applying the tax rate of 24% on the €25,000 income drawn down, which would be €6,000.
In choosing the special temporary annuity option for international pensions, the second percentage rate thereafter needs to be applied to the €6,000. The rate of tax for a temporary annuity of under 5 years is currently 12%. As such, tax is only payable on 12% of the €6,000; this equates to €720, or 3.33% of each €25,000 tranche of annual income drawn down.
In order to facilitate this, the pension trustees would reserve €75,000 in a protected account and provide an official document confirming that the temporary annuity option for foreign pensions has been claimed. The remaining capital in the fund of €425,000 would stay invested and will hopefully grow in the meantime. This basic calculation will differ in accordance with each individual’s personal allowances and regional tax rates; however, as a ball-park figure the principle holds true. For personal and specific advice, it’s important to speak to your financial adviser.
After the first 3-year period, you would simply repeat the exercise, if your situation is the same and the allowance is still in place. If either your situation has changed or tax rules have been altered, you would need to create a tax strategy that works under the new circumstances.
We are not alone in finding tax issues somewhat daunting. As Albert Einstein once said: “The hardest thing in the world to understand is income tax.” I hope he had a good adviser!