Do you pay tax on pension income?

Once you reach the State Pension age, you no longer have to pay National Insurance contributions (NICs), even if you choose to continue working.

However, you do still need to pay Income Tax.

Tax on income from pensions is calculated in the same way as earnings from employment.

Each tax year in the UK, you have a Personal Allowance. This is an annual tax-free amount, currently £12,570. Any income, including pension income, over your Personal Allowance is taxed.

The rate of Income Tax you pay depends on your total income for that tax year. The Income Tax bands are:

• Basic rate (£12,571 to £50,270) – 20%
• Higher rate (£50,271 – £125,140) – 40%
• Additional rate (over £125,140) – 45%

Be aware that additional rate taxpayers (those with a taxable income over £125,140) do not get a Personal Allowance.

These are the most current tax rates at the time of writing. However, they are subject to change. For the most up-to-date information, please visit the UK government’s Income Tax rates and Personal Allowances page.

Annual and lifetime allowances

There is a cap on how much you can pay into your pension and still benefit from tax relief.

These caps exist in the form of an annual and lifetime allowance. Once you exceed these allowances, a tax charge might apply.

Annual allowance

Your annual allowance is the amount you can add to your pension savings each tax year (6 April to 5 April) before you pay tax.

The current annual allowance is £60,000, which applies to all your private pension pots. However, your allowance may be lower if:

• You have a high income above £200,000 a year or;
• You take a flexible income from your pension plan

In some situations, you may be able to carry over any unused allowances from the previous three tax years.

So what happens if you exceed your annual allowance for the tax year? Not only will you not get tax relief on any contributions over the limit, but you will also pay an additional tax charge.

The amount you exceeded the limit by will be added to your other taxable income sources and subject to Income Tax.

Lifetime allowance

The lifetime allowance is the maximum amount of pension benefits you can build up over your lifetime before paying tax.

The current lifetime allowance (LTA) for the 2023/24 tax year is £1,073,100. Before 6 April 2023, you would have paid an LTA charge for going over your allowance. But as of 6 April 2023, there is no longer an LTA charge.

However, you will pay Income Tax on some or all pension lump sums over 25% of the standard lifetime allowance (£1,073,100). You may be able to increase your tax-free lump sum amount if you have lifetime allowance protection.

While the LTA is currently set at £1,073,100, it will be fully abolished from the 2024/25 tax year. This means from April 2024, there will be no limit to how much pension benefit you can build up over your lifetime.

Can you avoid paying tax on your pension?

The only way to avoid paying tax is to ensure your total annual income is below your Personal Allowance of £12,570. However, this is unlikely to be a feasible option.

A yearly income below your Personal Allowance will probably not be enough to cover the cost of retirement and support your desired living standard.

While it’s unlikely you can avoid pension tax altogether, there are ways to avoid paying more tax than your need to on your pension wealth.

Drawdown schemes

Pension drawdown, sometimes known as flexi-access drawdown, gives you more flexible options for making pension withdrawals.

By setting up a drawdown arrangement with your pension provider, you may be able to vary your annual pension income from year to year. Doing this can be a more tax-efficient way of drawing your retirement income.

Be aware that you do not have the same flexibility if you have an annuity, as you cannot vary the income they pay.

There are risks associated with drawdown options. Speak with a professional first to better understand your options and what suits you and your needs best.

Make use of ISAs

An ISA is a tax-efficient savings account. There are four types of ISAs:

• Cash ISA
• Stocks and shares ISA
• Innovative finance ISA
• Lifetime ISA

With an ISA, you do not pay tax on:

• Interest earned
• Income or capital gains

Any investment growth or interest is paid tax-free, meaning there is the potential for higher returns.

With an ISA, you have an annual allowance each tax year (6 April to 5 April). This is the amount you can put into an ISA each year. Currently, the yearly ISA allowance is £20,000.

You can use your allowance on one type of account or split it between accounts. However, you can only add up to £4,000 to a Lifetime ISA each tax year.

Withdraw what you need

You can do with your pension as you see fit. That means you can take as much of an income as you like.

However, taking more than you need could negatively impact the amount of tax you pay.

Remember, any pension income outside your tax-free amount is added to your total annual income. Taking more money than you need could lead to you paying more tax compared to leaving it in your pension.

Take advantage of the 25% tax-free amount

As mentioned, take advantage of the tax-free cash you can take from your pension.

You can usually access up to 25% of your pension without paying tax. For most schemes, you can do this from age 55, although this is rising to 58 in 2028.

You can take this tax-free amount as one lump sum or as smaller lump sums over a period of time.