Do you pay tax on your pension?
If you pay tax on your pension, here's everything you need to know about how pension withdrawals are taxed and one way you could reduce your tax bill.
Last Updated: 10 April 2024
In Q4 2023, HMRC processed 12,059 claims for overpaid tax and reportedly returned more than £38 million in overpaid tax to pension investors. On average, this means each of these people overpaid over £3,200 in tax on their pension withdrawals until they received their tax rebate.
With taxes having been historically on the rise and the cost-of-living soaring, it's important that you understand tax rules and don't pay more than you need to. Here's everything you need to know about how your pension withdrawals will be taxed - and one way you could reduce your tax bill.
This article isn't personal advice. If you're not sure what's right for you, ask for financial advice. Pension and tax rules can change, and benefits depend on your circumstances.
How will my pension be taxed in retirement?
Usually, you can take up to 25% of your pension tax free once you reach age 55 (rising to 57 in 2028). You can take this as a single payment, or in stages - it depends on what you decide to do with the rest of your pension. The rest of your pension is taxable, and when withdrawn, is added to any other income you receive in the same tax year.
If you have a defined benefit (e.g. final salary) pension, the scheme rules will affect how much tax-free cash you can get, and when you can take it.
Taking large or infrequent pension withdrawals could push you into a higher tax band and mean a hefty tax bill. It's important you plan for this before making any decisions.
When do you start paying tax?
There are three bands of income tax: basic rate (20%), higher rate (40%) and additional rate (45%). Most people can earn £12,570 per tax year without having to pay income tax - this is known as your personal allowance. You start paying basic rate income tax on all income over your personal allowance and higher rate on everything over £50,270. Additional rate is paid on income over £125,140. However, if your income is above £100,000, your personal allowance is reduced by £1 for each £2 you earn over the £100,000 limit, irrespective of age.
This means that if you earn £125,140 or more, you'll receive no personal allowance and all your income is taxed.
The table below illustrates the different UK tax bands. Different rates and tax bands apply to Scottish taxpayers.
| Income | Tax band |
|---|---|
| £0-£12,570 | Tax-free allowance |
| £12,570-£50,270 | Taxed at 20% |
| £50,270-£125,140 | Taxed at 40%. Personal allowance reduces once income exceeds £100,000 |
| £125,140 upwards | Taxed at 45%. Personal allowance lost entirely |
Find out how much your pension might pay
Remember that your State Pension is also taxable but the amount of tax you pay will depend on your total annual income. The maximum new State Pension you can receive is £11,500 a year, so if your income is only from the State Pension you won’t pay any tax. However, if your income from other sources pushes the amount over the personal allowance, income tax will apply.
How to avoid overpaying tax on pension withdrawals
Taking large withdrawals from your pension can push you into a higher tax band and lead to a hefty tax bill. There is less advantage to having more income than you need and keeping it in savings, so aim to take only as much as you need each tax year.
While it's important to avoid paying more tax than you need to, all pension withdrawals should be based on your personal circumstances and the need to support your lifestyle requirements in retirement.
Drawdown lets you vary your income from year to year which can potentially lead to tax savings. So, if in one year you need £25,000 and next year you need £20,000, you will pay £1,000 less in income tax if you are a basic rate taxpayer and withdraw only what you need compared to withdrawing £25,000 in both years. But remember, drawdown isn't the type of option which you can set up and leave. You need to be prepared to review your income and investments regularly. Your account's value will fluctuate which means it could even drop if your investments don't perform as you hoped. You could run out of money if you withdraw too much too soon, or you live longer than expected.
Married or in a civil partnership?
If you're married or in a civil partnership, then you could also make use of the marriage allowance to mitigate some tax liability on your pension payments.
If one spouse's income is below the personal allowance (non-taxpayer) while the other has an income of less than £50,270 (basic-rate taxpayer) the marriage allowance lets the non-taxpayer give £1,260 of their personal allowance to their spouse in the current tax year.
To put this into context, let's say you have an income of £10,000 and your spouse has an income of £30,000. Their taxable income would be £17,430 (as the first £12,570 is tax free).
As the non-taxpayer, if you claim marriage allowance, you could transfer £1,260 of your personal allowance to your spouse. Your personal allowance becomes £11,310 and your spouse gets a 'tax credit' on £1,260 of their taxable income.
HOW TO CLAIM MARRIAGE ALLOWANCE
Watch out for the emergency tax code
When you take your first taxable income payment from a pension, it's likely the emergency tax code will be applied. This code doesn't take other income into account and assumes you will receive the same amount each month. It's likely to result in the incorrect amount of tax being deducted initially, especially when making one-off lump sum withdrawals.
If you have a P45 from the same tax year that you intend to take your first income payment, you should send this to your pension provider as they might be able to apply the correct tax code using that information. Otherwise your provider will need to wait for your correct tax code to be confirmed by the HMRC. You can claim back any overpaid tax by contacting HMRC directly.
TRY OUR EMERGENCY TAX CALCULATOR
