The average person in the UK spends 36.2 hours a week at work. When factoring in the time it takes to get ready in the morning, commuting to work, commuting back, and overtime, a large chunk of our days revolve around work-related activities.
Most people have no choice since we all need food, a roof over our heads, and to save some money for retirement. By 2039, the retirement age is expected to increase to 68, meaning you may have to work a few extra years before accessing your State Pension.
Luckily, you can access your workplace or personal pension at age 55, which can help you reduce the number of hours you work leading up to your retirement. But, it’s not always clear if you have to pay Income Tax on it.
That’s what we’ll explore in this article. We’re going to look at if you pay tax on pension income, and if so, how much. We'll also look into the various pension schemes on offer and much more.
As a general rule of thumb, you will have to pay Income Tax on your pension as it is considered a taxable source of income. This will only be the case if your earnings from your pension, employment, savings, and property investments exceed the Personal Allowance threshold. For the current 2022/23 tax year, the Personal Allowance is £12,570 – this means that your total annual income up to this threshold is tax-free. Still, you will have to pay tax on all total earnings above this amount.
You will be taxed as a basic rate taxpayer (20%) on earnings between £12,571 and £50,270, as a higher rate taxpayer (40%) on earnings between £50,271 and £150,000, and as an additional rate taxpayer (45%) on earnings above £150,000. But, there are some caveats about how much tax you will have to pay, such as how much you withdraw and how often.
You don’t have to pay tax on all of your pension; some of it can be withdrawn as a tax-free lump sum. Currently, with a defined contribution pension – the most common type of pension scheme – you can withdraw 25% of your pension before you start paying Income Tax on it, and it does not affect your Personal Allowance.
For instance, suppose you have £100,000 in your pension savings. You will be able to take £25,000 as a tax-free lump sum. Your pension provider will then take tax off any withdrawals on the remaining £75,000.
You also have the option of taking a smaller pension lump sum with 25% of each withdrawal being tax-free, and then the rest of your pension income will be taxed as usual. Let’s look at the various withdrawal methods you can choose from.
There are different ways you can withdraw money from your pension, which will affect how much you are taxed:
- Leave your pot untouched – Since you aren’t withdrawing any money from your pension pot, you will not be taxed on any of it
- Guaranteed income (annuity) – You can withdraw 25% of your pot tax-free before you buy an annuity. The rest of the pot will be taxed as normal
- Flexible retirement income (pension drawdown) – You can withdraw 25% of your pot tax-free before the rest of the pot is moved to a flexible income. The rest of the pot will be taxed as normal
- Several lump sum withdrawals – 25% of each withdrawal will be tax-free. The remaining 75% will be taxed as normal
- Withdraw the full pot in one go – You can withdraw 25% of your entire pot tax-free. The remaining 75% will be taxed as normal
- A mix of the above – You can mix and match the above options when withdrawing from your pot. Your tax-free and taxable amount will vary depending on the options you mix
If you have a life expectancy of less than a year, you may have the ability to take out your full pension pot as a tax-free lump sum. In order for this to apply, you must satisfy all of the following criteria:
- You are under the age of 75
- You have a life expectancy of less than a year due to a serious medical condition such as a terminal illness
- Your pension savings do not exceed the Lifetime Allowance of £1,073,100
Unlike your savings in your bank account, the money in your pension pot isn’t considered ‘yours’ – it’s simply being held in a pension scheme waiting to be paid out. Therefore, when you are eligible to withdraw from your pension pots, HM Revenue & Customs (HMRC) considers this as another income source, making it taxable, like wages.
Income from your state pension is taxable, but how much you get taxed will vary depending on your total income and if it exceeds the standard Personal Allowance.
The maximum amount you can receive from the new State Pension is £9,628, which is below the Income Tax threshold. Suppose you do not receive income from other sources such as a workplace pension, employment, or investments. In that case, your State Pension will not be taxed. However, if you receive money from other income sources that put your annual income over the threshold, you will have to pay the basic rate tax of 20%.
For instance, suppose you receive the full new State Pension and have an annual annuity income of £8,500. Your total income for the tax year would be £18,128 (£9,628 + £8,500). After subtracting your tax-free Personal Allowance of £12,570, you have a taxable income of £5,558, which would be taxed at the basic rate (20%). This means that your Income Tax bill for the year would be £1,111.60.
The best way to avoid paying too much tax on your pension savings is to reduce your annual taxable income to below the Personal Allowance. This will result in you not paying any tax at all.
Having said that, it’s essential to withdraw as much as is necessary to lead a comfortable life – you certainly don’t want to worry about whether you have sufficient money to cover your bills and enjoy yourself. But, there are some measures you can take to avoid paying too much tax.
Only withdraw the exact amount you need each year
One way to achieve this is by only withdrawing the exact amount you need every year since excess withdrawals that aren’t being used will simply result in you being taxed more. It’s better to let the money sit in your pension pot tax-free rather than let it sit in your bank account after having been taxed.
For instance, if you need to withdraw £50,000 each year to live a comfortable life, then ensure you take out no more. Withdrawing £60,000 will simply mean you are taxed as a higher rate taxpayer on your earnings above £50,270. This is wasted money since you have a higher tax bill for no added benefit.
It’s also important to note that when you have reached retirement age, you’re not required to draw down your pension income and put it into savings. Therefore, you can avoid paying more tax by withdrawing less or not at all if it’s not needed.
Utilise a drawdown scheme
Another option is to take advantage of a drawdown scheme. Drawdown will let you decide how much you want to withdraw from your pension each year instead of a fixed amount.
For example, suppose you withdrew £30,000 in one tax year to cover your expenses. However, you know that next year you will only need £25,000. Instead of having to withdraw £30,000 again, you can choose to withdraw only £25,000. This will reduce your yearly tax payments from £3,486 to £2,386. That’s a £1,000 saving just from being able to choose to withdraw less.
If you have an annuity, you won’t be able to have this flexibility; you’ll have a fixed amount that is withdrawn each year regardless of your needs. It’s not all good news, though. Drawdown schemes come with risks since your pension money is invested in the stock market. Before making a decision, discuss the pros and cons of each with a financial advisor.
Take it out in one lump sum
This may seem like a contradiction to what’s been mentioned above, but taking out your pension put in one lump sum could be beneficial if you have a ‘small pot’. For smaller pension pots with a value of up to £10,000, withdrawing it all in one go may come with no risks.
You will still receive your 25% tax-free sum; the other 75% will be taxed as normal. Still, due to it being below the Personal Allowance threshold, you may find that you pay no tax on it if you have no additional income or that the taxable amount is not that high.
Take advantage of Pension Freedoms
The Pension Freedoms legislation was introduced in April 2015, giving people much more flexibility when withdrawing money from their pension savings. If you have reached pension age and your pension scheme has adopted the Pension Freedoms, you have complete control of when and how much you withdraw.
This allows you to tailor your pension withdrawals to suit all your needs, such as working around Income Tax, Inheritance Tax, and Lifetime Allowance Tax thresholds. However, some people may not have a well-thought-out pension plan which can result in you losing out large amounts of money by withdrawing too much, too little, or at the wrong time.
Therefore, speak to your pension provider if you have this flexibility. If you do, it’s wise to speak to a financial advisor about planning your pension withdrawals to minimise the tax you pay.
Just because you have reached the State Pension age, it doesn’t mean you cannot work. Many choose to continue working in a job they enjoy or to pass the time. You can earn money via employment or self-employment while withdrawing money from your pension pot(s). However, it’s important to remember that this will increase your tax bill and could potentially put you into the higher tax band.
If you have multiple sources of income, you may find that you are taxed differently for each income source. It’s crucial to stay on top of this so that HMRC doesn’t deem you to be avoiding your tax payments.
|Income source||How it’s taxed|
|Full-time employment||Tax will be deducted automatically by your employer using Pay As You Earn (PAYE)|
|Self-employment||You will have to make tax payments directly to HMRC via a Self Assessment tax return|
|Personal pension||Your pension provider will deduct tax automatically|
|State Pension||HMRC will deduct tax automatically|
|Savings (excluding ISAs)||You will have to make tax payments directly to HMRC via a Self Assessment tax return|
|Investments||You will have to make tax payments directly to HMRC via a Self Assessment tax return|
|Rental property||You will have to make tax payments directly to HMRC via a Self Assessment tax return|
Your pension is considered taxable income, meaning you will have to pay Income Tax on it. Luckily, in most cases, 25% of your withdrawals will be tax-free, ensuring you’re not paying taxes on the full amount. However, the exact amount you pay will vary depending on your pension scheme and withdrawal methods. It’s best to get in touch with your pension provider for full details on your situation before making any withdrawals.