If you’re approaching retirement and will soon be drawing your defined contribution (DC) pension – or perhaps you’re still working but, having hit the age of 55, want to access your funds – you’ll need to know how tax comes into play. Here, we take a closer look at everything you need to know about tax and your pension, to avoid any unwelcome tax charges later down the line.
The most important thing to remember is that any money you take from your pension is classed as income, which means you’ll pay income tax on all withdrawals. This applies no matter how you choose to withdraw the money, whether it’s through an annuity or income drawdown, or if you take your whole pot in one go.
The exception to this is the pension commencement lump sum which is usually 25% of your pot, which you can withdraw tax-free.
The personal allowance still applies, which means you won’t pay any tax on the first £12,570 of income (in the 2021/22 tax year) – though bear in mind that this includes income from the state pension – and will pay 20% income tax on anything between £12,571 and £50,270, at which point the higher rate of 40% kicks in. Any earnings over £150,000 a year will be taxed at 45%.
However, as your pension provider will use the Pay As You Earn (PAYE) system, your first pension withdrawal will probably be overtaxed. This is because your provider won’t know your tax code and so an emergency code will be applied, which assumes that the payment you receive will be repeated each month as if you were receiving a regular salary. This payment could be significant, and could mean you’re pushed into the higher rate of tax. You can actively reclaim this overpaid tax by contacting HMRC and filling in the required forms, or they should automatically refund it at the end of the tax year.
All income is taxed, and given that pension payments are classed as income, it follows that your pension will be taxed too. However, remember that you benefit from tax relief when paying into your pension, and the tax-free lump sum element boosts the tax-efficiency of pension saving even further.
No. Pension income is taxed the same as all other income subject to income tax, the only difference being the 25% tax-free element. However, National Insurance contributions are not payable from pension income.
No. You can only take 25% of your pension as a tax-free lump sum, and will be required to pay income tax on the rest, no matter how you choose to draw it. If you opt for an uncrystallised funds pension lump sum (UFPLS) arrangement, this is a way of taking lump sums from your pension as and when you wish, as you won’t have previously taken the tax free lump sum, 25% of each withdrawal is tax-free and the rest being taxed at your marginal rate.
While it’s possible to withdraw your full pension pot as a lump sum, the tax charge for doing so could be substantial. After discounting the initial 25% tax-free element, you’ll be taxed on the remaining 75% in one go, which, depending on how big a pot you’ve accumulated, could push you into a higher-rate tax bracket and mean that almost half of your remaining pot goes to the taxman. Then there’s the fact that if you take everything in one go, you’ve then got to decide how you’ll turn that lump sum into an income for the rest of your life, which could prove difficult, particularly if lots of it has been spent on tax.
For these reasons, it’s probably best to plan things a little better and gradually withdraw funds from your pension pot, either through UFPLS or investing in drawdown, with the latter option still allowing you to withdraw a 25% tax-free lump sum at the outset, which could offer the ideal compromise. The other option is to purchase an annuity for a guaranteed income, though again, you can still benefit from the initial lump sum at the beginning of the arrangement.
If you’re opting to ‘crystallise’ your full fund – i.e. use it to purchase an annuity or income drawdown – you can take one tax-free lump sum from your pension. The same applies if you’re considering taking the full amount in one go, with 25% of it being tax-free. If you’re considering UFPLS, you can take as many lump sums from your ‘uncrystallised’ pension as you wish (though some pension providers may impose their own limits), with a portion of each lump sum being tax-free.
Yes, though as discussed, this will result in you being taxed on the full amount in one go (excluding your tax-free allowance), and means you’ll need to think carefully about how to make your cash lump sum work harder to provide an income throughout retirement. If you’re looking for advice on the best way to access or invest your pension savings, get a free one-hour savings and investment review with Kellands Hale.
Typically speaking, pensioners won’t need to lodge a tax return, provided their only income is from their pension. If they have any other form of income – such as a buy-to-let property, investment/dividend income outside of an ISA, or a business – they’ll need to fill in a self-assessment tax return accordingly.
Your state pension counts as income for tax purposes, so if your total annual income – including your state pension and DC pension – exceeds your personal allowance, you’ll be taxed at your nominal rate. However, if you’re only in receipt of the state pension and don’t have any other form of income, it’s likely that you won’t be breaching your personal allowance, and so you could receive it tax-free. It all depends on your individual circumstances.
Yes. The income from your state pension, no matter when you choose to receive it, is taxable and will be collected accordingly. However, if you’re eligible to receive the deferred amount as a lump sum – which may apply if you reached state pension age before 6 April 2016 and have deferred since then – you’ll only be taxed at the rate you’re paying in the year you claim it, even if it the amount pushes you into a higher tax bracket.
Yes. Whether you’ve got a workplace pension or have arranged one privately, you’ll be subject to the same pension tax rules.
Yes. This means that if you’re in receipt of means tested benefits, such as income based jobseeker’s allowance or income support, your pension income could affect your eligibility.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.