Guide to Tax and Pensions
Pensions play a vital role in providing financial stability when we stop working. That is why it's essential to understand how tax on pensions works. Read our pension tax guide to learn moreSpeak to a pension expert
Pensions are a core component of any retirement planning strategy.
They act as a regular source of income and help provide financial stability when we stop working.
However, pensions are not exempt from tax.
When it comes to planning for retirement, understanding pension tax implications is crucial. That way, you can make the most of your retirement savings.
This pension tax guide will provide a comprehensive overview of the topic, covering important information to help you better understand tax in retirement.
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.
What counts as taxable income?
You pay Income Tax on pension savings if your total annual income exceeds your Personal Allowance.
But your total annual income includes more than just your pension. According to the UK government, your total income could include:
- The State Pension (either the basic State Pension or the new State Pension)
- A private pension – this includes workplace pensions or personal pensions
- Any taxable state benefits
- Earnings from employment or self-employment
- Any other income, such as money from property, savings or investments etc.
Tax on pension contributions
Pensions can be a tax-efficient way to save for retirement. That is because, in the UK, pension contributions benefit from tax relief.
With pension tax relief, some of the money you add that would otherweise have gone to the government as tax goes into your pension fund.
In the UK, the amount of tax relief you get depends on your Income Tax band.
- Basic-rate taxpayers – 20%
- Higher-rate taxpayers – 40%
- Additional rate taxpayers – 45%
You get tax relief on pension contributions worth up to 100% of your annual earnings. But there are some limitations that we will cover in the next section.
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.
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.
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 I take some of my pension tax-free?
The minimum pension age, the earliest age you can access your pension savings, depends on the pension provider and scheme. But for most, the minimum pension age is 55.
You typically won’t pay tax if your total annual income is less than your income tax personal allowance of £12,570.
Depending on the type of pension scheme, you may be able to access some of your pension tax-free if you are a UK tax resident.
Defined benefit pensions
A defined benefit (DB) pension, also known as a career average pension or final salary, pays an income for life.
This income is taxed in the same way as earnings from your job, meaning you will pay income tax on income over your Personal Allowance. Some DB pension schemes also provide a pension commencement lump sum (PCLS).
PCLS, often known as ‘tax-free cash’ or a ‘tax-free lump sum’, is a tax-free payment that most people can receive when they start accessing their pension benefits. It is normally 25% of the value of the pension benefits being accessed as a tax-free lump sum.
Defined contribution pensions
Most workplace or personal pensions are defined contributions schemes. Thanks to the Pension Freedoms, these schemes usually let you take a 25% tax-free cash lump sum.
This is usually taken as a single lump sum. However, you may also be able to withdraw multiple smaller lump sums, with 25% of each being tax-free.
For example, let’s say you have a pension pot of £1 million. If you access all of your pension pot at once, you could take £250,000 (25% of £1 million) tax-free, while the remaining £750,000 would be treated as earnings, meaning you would pay Income Tax on that amount.
Alternatively, you could take a smaller cash lump sum of £3,000 per month. In this scenario, £750 (25% of £3,000) would be tax-free, while the remaining £2,250 would be treated as taxable income.
Is the State Pension taxed?
While the UK State Pension is paid to you before any tax is deducted, it is treated as taxable income.
If the UK State Pension was your sole source of income, you would not pay Income Tax. The current maximum State Pension amount is just over £10,600 a year (£203.85 a week). That is £1,970 below the Income Tax Personal Allowance.
But once you factor in other sources of income, such as private pensions and investments, your total annual income is likely to exceed your Personal Allowance for Income Tax.
Pension tax for expats
Several factors determine if and how much tax you pension tax you pay as an expat.
You may have to pay UK tax on your pension if you are classed as a UK resident for tax purposes. The rate of tax you pay would depend on your income.
You should be aware that if you are not a UK resident, you may have to pay pension tax in your country of residence.
Depending on where they are located in the world, there may be tax advantages for expats who take their pension in another country by leveraging double taxation agreements (DTAs).
DTAs are treaties that exist between two countries, designed to protect against the risk of being taxed on the same income twice. The UK has over 120 DTAs in place with countries worldwide.
Those living in a country with a zero Income Tax rate, such as the UAE, may be able to access their pension without any tax penalties.
Tax liability can be a complex topic for expats. It is recommended that you seek independent, professional advice to better understand your pension choices and to help ensure you are as tax-efficient as possible.
Tax when you have multiple sources of income
Having multiple sources of passive income can help build a more solid financial foundation for retirement.
Some examples of passive income include:
- Income from investments
- Rental income from a property investment
- Interest from savings accounts
- Annuity income
If you have multiple sources of income, you are responsible for paying any tax, such as Income Tax or Capital Gains, that is owed. You may need to complete a self-assessment tax return with HMRC to do this.
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.
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.
Pension tax planning with Holborn Assets
Pension tax rules and regulations can be complex. But understanding them to ensure you are as tax-efficient as possible can help you maximise your retirement savings.
Seeking professional financial advice can help you identify and avoid some of the possible pension tax pitfalls.
At Holborn Assets, our financial advisers provide expert advice on tax issues relating to pensions, as well as other key services to help you plan for the future.
We work closely with clients to help them better understand their retirement options and develop tailored strategies based on their individual circumstances and goals.
Make sure your future plans remain on track. Book a free, no-obligation meeting today and learn how we can help you make the most of your pension savings.