Like any form of income, most money you take from your pension is subject to income tax. However, with careful planning you can manage your tax bill in retirement and prevent unnecessary losses.
To make sure you’re getting the most from your retirement savings, it’s important to understand how tax on pensions works, and how it could affect your retirement income.
Drawing income from your pension pot
If you have one or more workplace pensions or personal pensions, each of these will be a pot of money from which you can draw an income from the age of 55. When you do, 25 percent of what you draw out will be completely free of tax. You can do this all in one go (people call this the ‘tax-free lump sum’), or you can draw a series of smaller lump sums, with 25 percent of each being tax free).
The rest of the money you draw from your pension pots is taxed as ordinary income. Any other income you may have (e.g. the State Pension) is also included in the total. So if the total rises above your personal allowance, you will start to pay income tax – first at the basic rate and then at the higher rate, if your income is large enough in any given year.
Managing your tax bill – why you need to take care
Today’s pensions give you a lot of freedom to take the level of income you want. You can even draw out a whole pension pot as a lump sum. However, you should be very careful when doing this, and always seek advice first. This is because a large single withdrawal may result in a lot of taxable income in that year.
For example, if you have a pension pot of £100,000 and take £25,000 as your tax-free lump sum, then also take out the remaining £75,000, your taxable income will be £72,094 (if you also are receiving the full State Pension). Of this, £32,000 will be taxed at 20 per cent, and £40,094 will be taxed at 40 per cent – leading to a total tax bill of £22,437.
However, for a very small pension pot (which you might have from a short-term job), it may be possible to take the whole sum out without pushing your income too high. Alternatively, you may want to combine your pensions into a single fund. Talk to your adviser about the best course of action.
Can it make a difference how I take my pension income?
There are several different ways to draw your pension. Some of these may make it easier to manage your tax bill than others.
For example, with drawdown you can vary your annual income, so you could choose to reduce it if in a particular year your received income from another source, which might increase your tax bill.
However, if you have an annuity you will receive a fixed income every year – even if you don’t need it for whatever reason. This means that, if you were to receive additional income from another source, your annuity might result in a higher tax bill.
Whether or not these issues affect you will depend on your lifestyle in retirement.
Is there any other pension tax I should know about?
Income from your pension can be subject to an additional tax charge if your pension has grown very large, and so exceeded the lifetime allowance.