How is your pension taxed when you retire?
When you retire, the pension you draw is subject to income tax. Here’s what you need to know – including how to make sure you aren’t overpaying.
Pensions are long term investments. You may get back less than you originally paid in because your capital is not guaranteed and charges may apply.
Saving into a pension is incredibly tax-efficient because your contributions usually attract tax relief. When you come to retire, however, you will have to pay income tax on money drawn from it.
The good news is that the first 25% of your total pot is nearly always tax-free. How much tax you’ll have to pay on the rest depends on your yearly income, so it’s important to think carefully about how much you need and where you take it from.
Here’s how to make sure you don’t overpay unnecessarily.
Make the most of your tax-free ISA allowance.
What is pension tax?
You pay income tax on your pension, in the same way that you pay it on a salary when you have a job. However, the rules are slightly different.
How much tax do you pay on your pension?
As with employment, if your total earnings in retirement are more than £12,571 then you’ll start paying income tax. The thresholds after that are the same as for employment earnings.
| Band | Taxable income | Tax rate |
|---|---|---|
| Personal Allowance | Up to £12,750 | 0% |
| Basic rate | £12,751 - £50,270 | 20% |
| Higher rate | £50,271 - £150,000 | 40% |
| Additional rate | Over £150,000 | 45% |
When you’re calculating your income, you need to think about everything you’re receiving money from – including your state pension and any taxable income from other sources such as savings or a buy-to-let property.
The main difference between pension tax and tax on employed income is that you get 25% of your total pension pot (not including the state pension) tax-free. This is limited to £268,275 from April 6, 2023 onwards.
Some people choose to take this as a tax-free lump sum when they retire. This is relatively straightforward, as you pay nothing on that amount, and pay income tax according to the bands above on everything that you take afterwards.
However, you also have the option to spread your tax-free sums. This means you can take a series of lump sums, and for each one, a quarter will be tax-free. Only the remaining 75% of each lump will be subject to the bands above.
When you withdraw from your pension the income tax is deducted automatically by your pension supplier.
Do you pay tax when you withdraw a lump sum from your pension?
When you reach retirement age you have the option to make a one-off withdrawal worth 25% of your entire pension fund.
This withdrawal is tax-free, meaning you get the full amount without any deductions as long as it's less than £268,275.
Any withdrawals that exceed 25% of your pension fund will have income tax deducted.
For example, if you withdraw £60,000 (60%) from your £100,000 pension fund, you pay income tax on £34,500 (the amount above your 25% tax free withdrawal).
Is it better to withdraw all of your pension at once?
No, making a large withdrawal could force you into a higher income tax bracket for the year.
You could keep yourself in a lower income tax bracket by:
Withdrawing your 25% tax-free lump sum
Spreading the rest of your pension over your retirement
For example, suppose you have a £100,000 pension pot. You can take £25,000 tax-free, but the remaining £75,000 is subject to income tax.
If you take the remaining £75,000 in one go, and have no other source of income that year, that £75,000 would be treated as follows:
£12,570 will be tax-free.
£37,700 will attract tax at the 20% rate – so you’ll pay: £7,540
The remaining £24,730 will attract tax at the 40% ate – so, you’ll pay £9,892
Total tax paid: £17,432
If you take the same £25,000 lump sum tax-free, but split the remaining £75,000 over three years – you’ll have an income of £25,000 each year.
For each of the three years, your calculation will be:
£12,570 will be tax-free.
The remaining £12,430 will attract tax at the 20% rate – so you’ll pay: £2,486
Total tax paid over three years: £7,458
By splitting the payments across three years, you’ll save £9,974 in unnecessary tax bills.
Speak to an independent financial adviser before making a decision, they can help you structure your withdrawals tax efficiently, and ensure you have enough cash to last through your whole retirement.
Are your pension contributions taxed?
The government gives you an annual allowance that means you get tax relief on the first £40,000 you pay into your pension each year if you meet certain conditions, rising to £60,000 from April 6, 2023. Everybody gets at least 20% in relief.
This means that if you put £100 of your money into a pension, you’ll get tax relief worth £20 – bringing the total contribution to £120.
How much relief you’re entitled to depends on what rate taxpayer you are. If you pay a basic rate, you’ll get 20% back, higher rate payers can claim 40% and additional rate payers can claim 45%.
If you pay your pensions contributions out of pre-tax earnings, you’ll automatically get the right amount of relief. If you’re paying in from your post-tax earnings, you may have to claim the additional relief from the government via a self-assessment form
Even though the annual allowance is £40,000, you can only contribute up to the value of your annual salary each year, or £3,600, whichever is higher.
Can you build up your pension allowance?
Yes, you may be able to carry forward unused annual allowances from the previous three tax years.
Your pension allowance for the last few years were:
| Tax year | Annual allowance |
|---|---|
| 2019/20 | £40,000 |
| 2018/19 | £40,000 |
| 2017/18 | £40,000 |
To find out how much unused allowance you had from the last three tax years, contact your pension supplier or speak to an independent financial adviser.
As well as an annual limit, there is a lifetime limit on how much you can have saved up in all your pensions combined.
The lifetime limit is currently £1,073,100, but it's being scrapped from April 6, 2023.
Importantly, this limit is set by what’s in there - not by what you pay in.
So if your pension has been performing well and growing strongly you could hit this limit sooner than you think. This is especially true when you consider you could have more than 40 years’ worth of interest built up over a working lifetime.
What happens if you go over the limit?
You will not get any tax relief on any contributions over £40,000 a year, rising to £60,000 from April 6, 2023, or the total value of your salary income limit (whichever is lower).
For example, if you pay £60,000 into your pension in one tax year, you will be taxed on £20,000 (£60,000 minus £40,000).
If you think you could exceed your pension contributions limit for the year, speak to an independent financial adviser to discuss an alternative way to save towards your retirement.
If you go over the lifetime allowance, any future growth in your pension fund will have tax deducted from it - although the fund will do that for you.
Your pension provider will write to you to let you know how much tax is due.
How are pensions taxed when you die?
This depends on how old you are when you die:
If you are under 75, or have yet to touch your pension, it can be passed on tax-free.
If you are over 75, whoever inherits your pension will pay income tax on it.
Find the best personal pension plan to make your money work as hard as it can.