After saving away or paying into workplace schemes and National Insurance for a lifetime, it seems like a kick in the teeth for HMRC to then take a bite out of your money as soon as you start claiming it. But it can. Here are the rules for when you do – and don’t – pay tax on a pension
Even people who get nothing more in retirement than their state pension could end up paying tax on that income – in fact, the time is soon coming when most will unless something drastic changes.
But there are also times when your retirement savings can arrive tax free, provided they’re held in the right sort of accounts.
So, who already pays tax on their pensions, how much are they charged and what can you do to escape it?
We explain exactly how tax on pensions and retirement savings work below:
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What is taxed on a pension?
It’s an uncomfortable truth that, while pensions largely escape tax while you’re paying into them, that goes out the window the moment you start drawing an income from it.
However, there’s a big difference between the way state pensions work and what happens with any private or workplace pensions you have.
Is the state pension taxable?
The state pension is a benefit paid by the government to people who qualify for it. Like many other benefits, it’s taxed as if it’s income from a job.
That means if you’re lucky enough to make more from your state pension than your annual tax-free allowance – £12,570 a year or £245.19 a week – you’ll pay tax on it.
Currently, that only applies to some of the people on the old system of a basic state pension topped up by a second, or additional, state pension.
However, very soon it will apply to everyone on the new state pension. The current full state pension – applying to everyone who reached retirement age after April 6 2016 – is £241.30, just £4 lower than the tax-free allowance.
From a pensions perspective, this is – oddly – a reason to celebrate rather than get angry as it means the new state pension has risen fast enough to catch up with the tax-free allowance that applies elsewhere.
It’s also a rather neat example of how not changing the tax-free allowance since 2021 (and with no plans to raise it until 2030) draws more and more people into paying income tax.
From next year – when the full state pension is almost certain to cross the threshold – you’ll pay 20% income tax on any money you earn (state pension included) between £12,570 and £50,270 a year and at least 40% on any income over that amount.
Do you pay tax on personal pensions?
Personal pensions, or private pensions, are taxed as income. Well, mostly.
The big difference between income from a state pension and income from a private or personal pension is that there’s a 25% tax-free allowance for people drawing from private pensions.
This is capped at £268,275 – but you’ll need a whopping £1,073,100 saved in personal pensions before this applies to you.
You can draw all of this 25% out at once as a lump sum, or get the first 25% worth of ongoing payments exempted from tax.
However, there are a couple of exceptions to this rule. Firstly, it’s not possible to take the 25% as a series of payments if your pension is based on your earnings at work (normally a final salary or career average salary scheme) where your payout is what’s guaranteed when you pay in. You can only pull the money out as a lump sum in those cases.
Secondly, if you have a small pension pot saved up – less than £10,000 for example – you don’t get to take 25% of that tax free and leave the rest there. Instead you need to pull the whole thing out, and you’ll get tax relief on a quarter of it instead.
Different ways to withdraw your personal pension
Currently you can start withdrawing money from your personal pension at the age off 55, although this is rising to 57 from April 2028 onwards.
These are the different ways you can access your personal or private pensions – exactly what options you have depend on the type of pension you have and your provider’s rules:
- Take is as cash – simply pull some, or all, your money from your pension into your bank account to do with as you like
- Flexible drawdown – in this scenario you can decide how much you take from your pension, if anything, each month. The rest is left in your pension pot where it can grow tax-free
- Phased drawdown – this lets you move some of your money into your drawdown pot, leaving the rest protected. It’s designed to help you manage your money in retirement
- Get an annuity – in this scenario you use some or all of the money you’ve saved up to buy a regular income guaranteed for life
- Regular income for life – this applies to people who have a defined benefit pension, where what you’re paid out in retirement is fixed as a percentage of what you earned while working. Currently it’s almost only available to public servants.
Do you pay tax on your pension lump sum?
As long as you don’t withdraw more than 25% of a pension pot – up to a maximum of £268,275 – the lump sum is tax free.
You can, of course, choose to take less than 25%, or take nothing at all, but four out of five pensions savers opt for a lump sum.
If you’re cashing in a small pot of less than £10,000 – rather than consolidating it with a larger pension – then the rules change. In this case you cash in the full amount, with 25% of that being tax free, and the rest is taxed as if it was income from a job.
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What isn’t taxed on a pension?
Money that’s held in a pension fund isn’t taxed until you withdraw it – so no income tax and you won’t pay capital gains tax on it either.
Additionally, money paid into a pension escapes income tax (and possibly national insurance too) until it’s withdrawn.
That means if you think you’ll be in a lower income tax bracket in retirement than you are when you’re working, you can effectively get a big boost to your overall income by saving money from your earnings (that would have been taxed at 40% or even 45%) and drawing on it later in life (where you might only have 20% income tax applied).
If you’re saving straight from your pay at work, you can often also take advantage of “salary sacrifice” – where you effectively earn less money, with that cash going straight to your pension instead. This lets you dodge national insurance as well as income tax on your earnings.
There is, however, a limit on how much you can pay into your pension each year – this is capped at the lowest of £60,000 or your annual salary.
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How much can I earn tax-free?
You can take 25% of your private or workplace pension tax-free after the age of 55 – rising to 57 in 2028.
After that, the first £12,750 you draw each year is tax free. Although this includes payments from the state pension.
There is also a savings allowance, where the first £1,000 of savings interest you make each year is tax-free for basic rate taxpayers. This drops to a £500 tax-free allowance for higher-rate taxpayers.
How to calculate tax on pension income
The first thing to be aware of is that state pensions and private pensions both count as income for tax purposes.
To work out what tax you’ll pay, add both sums together to get an annual total. There are slightly different rules in Scotland to the rest of the UK
- The first £12,750 of this will have no tax applied
- Money earnt between £12,571 and £50,270 will have a 20% income tax applied
- Money earnt between £50,271 and £125,140 will have 40% income tax applied
- Money earnt above £125,141 will be taxed at 45%
There’s an extra twist for people lucky enough to earn more than £100,000 a year too. Every £2 you earn over £100,000 sees your personal allowance drop by £1. That means that by the time you earn £125,140 there is no person allowance left and you pay tax on everything you earn on your pension.
In Scotland, the tax brackets change to:
- The first £12,750 of this will have no tax applied
- 19% tax on the next £3,967 earned (£16,717 total)
- Then 20% tax on the next amount up to £16,956
- 21% tax on the next bit up to £31,092
- 42% tax on the next slice up to £62,430
- 45% tax on the next part up to £125,140
- 48% tax on money earned over £125,140
How can you avoid paying tax on your pension?
Maybe – but you probably don’t want to.
Put simply, the only legal way to avoid paying tax on a pension is to make less than the annual allowance.
Assuming you don’t want to get by in retirement on less than £245.19 a week there is one other trick you can use.
Lifetime ISAs don’t pay you back all the income tax you pay on your earnings like pensions do, but they do top up your contributions by 25%.
They are also capital gains tax and income tax free when they grow.
The even better news is that if you can wait until after you’re 60 to access your cash, there’s no tax at all due on withdrawal.
The downsides are that you can only save £4,000 a year into them, need to be aged between 18 and 40 to open one, and they stop paying the government bonus after you turn 50.
Oh, and they’re about to be withdrawn from the market.
But, if you qualify and you’re quick, you can build up a rather nice little lump sum that will keep growing for 20 years and be tax-free when you take it out in retirement.
That’s on top of the 25% tax free pensions cash that’s on offer.
