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How will my pension be taxed when I take it?

We take a look at your options at retirement, how your pension will be taxed and what you could do to make your tax bill smaller.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

We pay tax on our income throughout our lives, and we’re well aware of seeing our reductions on our pay slip. But being taxed on our income in retirement isn’t always so clear cut.

It’s important you understand how your pension will be taxed when you take it. If you don’t, it could mean you’ll end up paying more tax than you need to.

This article isn’t personal advice. It’s based on our understanding of the rules in the 2020/21 tax year, but tax rules can change and benefits will depend on your personal circumstances.

How much of a pension is tax free?

Usually up to 25% of your pension can be taken completely tax free, once you reach age 55 (rising to 57 in 2028).

If you have a defined benefit (e.g. final salary) pension, the scheme rules will affect how much tax-free cash you can take and when you can take it.

Defined contribution (e.g. self-invested) pensions usually offer more flexibility, meaning you can decide when and how to take your pension. You can typically take your tax free cash as a single payment, or in stages – it depends what you decide to do with your pension.

What are my options?

If you want your tax-free cash and an income on top, there are three options you could consider.

  1. Many people decide to take their tax-free cash, but don’t need to take an income from their pension just yet. You can do this by moving your pension into drawdown.

    You’ll normally get up to 25% of the amount you use as a tax-free cash payment, and the rest will stay invested as you choose. You can make withdrawals (this will be taxed as income) from your investments when you’re ready.

  2. You could use your pension to buy an annuity (which provides a guaranteed income for life). You’ll normally receive up to 25% of your pension as a tax-free cash payment, but the rest will be exchanged for a regular, secure income (which is taxable).

  3. Another option is to make taxable withdrawals from your investments as and when you need to.

    So instead of just taking the 25% tax-free amount in one go, you could decide to take lump sum withdrawals from your pension, where usually 25% of each withdrawal will be paid tax-free, then the rest will be taxed as income. You could even withdraw your whole pension as one lump sum if you wanted to.

You might also want to take a look at the government’s Pension Wise service, which offers a free impartial service to help you understand your options.

More about your options

Things to consider

With drawdown and lump sum options, you need to carefully consider how long you need your pension to last. Unlike an annuity, your income isn’t guaranteed because investments, and the income they produce, can fall as well as rise in value. You could get back less than you invest. Taking a lump sum or income from drawdown will also restrict what you can put into a pension in the future.

Excessive withdrawals or poor investment performance can also deplete a pension fund, potentially leaving you short of income later on in retirement – so ultimately you could get back less than you originally invested. Taking control of your own income in retirement is a big decision. So if you do, make sure you’re prepared to keep on top of your investments and review them to make sure you stay on track of your retirement goals.

How is the rest of a pension taxed?

This is where it’s important to be savvy about being taxed in retirement.

The rest of your pension (after any tax-free cash) is taxed as income and is added to any other income you receive in the tax year. This means taking large withdrawals could push you into a higher tax band – and land you with a hefty tax bill.

Standard tax bands based on a personal allowance of £12,500 in 2020/21

If you’re a Scottish tax payer, remember different rates and bands apply.

For most people the first £12,500 of taxable income won’t be taxed as it falls within the standard personal allowance – just like your income when you’re still earning.

For income above this amount, different tax bands and tax rates apply, rising to 45% on income over £150,000. The personal allowance will vary depending on your circumstances, and starts to reduce once income rises above £100,000, falling to zero for income of £125,000 or more.

If you’re not sure about what this might mean for a one-off large withdrawal you could use our income tax tool to help.

income tax calculator

How can I avoid paying more tax than I need to?

If you’ve got a defined contribution pension scheme, then there’s no rule or requirement to take your whole pension in one go. You can choose to take money from your pension as and when you need it.

One option to avoid overpaying tax in retirement is by making the most of tax allowances and bands. If you spread your withdrawals over more than one tax year it’s likely you’ll end up paying less tax.

The tax year starts on 6 April and runs to 5 April the following year. Each year you get a new personal allowance and your full allowance restored in each tax band. This is something you could take advantage of.

Let’s say you took out £30,000 as income from your pension, but you’d already made withdrawals of £35,000 from your pension that tax year. Taking the additional £30,000 in the same tax year would mean you’d pay a total of £13,500 in income tax. If you split the £30,000 across two years (i.e. £15,000 each tax year), assuming you have no other income in the second of the two tax years, you’d only have to pay £8,000 in income tax across the two tax years. This means you keep an extra £5,500 in your pocket.

When might investors overpay tax?

All pension providers will deduct tax, where appropriate, before paying any withdrawals to you. But if you don’t have a valid P45, HMRC will usually require your provider to tax your first pension payment using the emergency tax code. This is likely to result in the incorrect amount of tax being deducted initially.

You can contact HMRC directly to settle any underpayment or overpayment of tax. Or HMRC might adjust your tax code so that any overpayment or underpayment of tax is corrected in the next withdrawal you take.

To estimate how much tax might be deducted from your pension withdrawals under emergency rate, try our calculator.

emergency tax calculator

Save on tax – pass on your pension tax free

Passing on your pension after you die might not be on top of you priority list when you come to retire. But it could be something to consider when thinking about saving tax.

In most cases there’s no inheritance tax on pensions. So it could be a sensible choice to make withdrawals on other savings before your pension, if you have them.

Anything withdrawn from an ISA is tax free, for example. So you could use your ISAs to supplement your pension income, leaving more of your pension intact to pass onto your loved ones.

In most defined contribution schemes, anyone can benefit from what’s left in your pension after you die. You can nominate as many people as you like as beneficiaries and update them at any time – just let your pension provider know who they are, and how much you’d like to leave them.

These nominations normally aren’t legally binding, but they let your provider know your wishes and they must be taken into account when you die.

If you die before age 75, your beneficiaries won’t usually need to pay any income tax on the withdrawals they make. If you die at or after 75, then withdrawals will be taxed as their income.

It’s also possible to pass on your annuity to loved ones too, but you need to build these features in when you set it up, otherwise the payments will stop once you die.

Download our guide

Find out more about tax in retirement by downloading our guide, there’s more detail on:

  • How withdrawals are taxed
  • What different tax codes mean
  • How to claim back over-paid tax

Download guide

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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