How is my pension taxed when I retire?

Do you pay tax on a pension?

Yes. HMRC treat the money you get from your pension when you retire as income, so you pay tax on it in much the same way you do when you are earning a salary. The bigger your annual pension income, the more tax you pay, so it’s important to only take what you’ll use – otherwise, you could face an expensive and unnecessary bill.

How much tax do you have to pay?

Most people get a personal allowance: a portion of your income that you don’t pay any tax on. At the moment, the allowance for most people is £12,570. However, your personal allowance starts to reduce once you earn more than £100,000 a year (whether from a salary, rental fees or your pension). You pay tax on any income above your personal allowance per the following bands.

The 2023-4 income tax bands are:

You only pay higher rates of tax on the proportion of income that falls in each bracket. For instance, if you earned £90,000, you’d pay nothing for the first £12,750, 20% on the amount up to £50,270 and 40% on the remaining £39,730.

Remember, it’s not just your pension that determines your tax rate. If you’re a landlord, any rent you get will count towards your income, even if you’re retired. Equally, if you are still working while drawing your pension, your salary is included when determining your tax position. Even savings interest and investment returns count (if they’re not in an ISA or pension). 

State Pension

You receive your state pension gross (before tax) every four weeks. You need to include this in your total earnings for tax calculation purposes. The current state pension is £10,620 per annum. If it’s your sole source of income, you won’t be taxed because it’s less than the personal allowance. However, if you have other cash coming in and breach that threshold, you will pay income tax.

How does the state pension work

Private or workplace defined contribution pensions

If you’ve got a private pension, such as a SIPP, or a workplace defined contribution pension, you have several options for taking your money at retirement. It’s important to consider your tax position carefully when deciding what to do. 

Learn more about how to withdraw your pension

For instance, while taking your whole pension in one go might be possible, this may push you into a higher tax bracket, meaning you’ll hand a chunk straight over to the taxman. 

Taking a sum each year, either by buying an annuity or through a drawdown arrangement, will spread out your income, meaning you pay less tax.

Learn more about income drawdown.

Another important thing about defined contribution pensions is that 25% is tax free. Many people choose to take this as a lump sum up front. It doesn’t count towards your total income for tax purposes and won’t affect your personal allowance. 

Alternatively, you could take your pension as a series of lump sums, where each lump is 25% tax free. The total amount of tax-free cash will be broadly the same, but you’ll be spreading the benefits over several years. 

Used wisely, this could help improve your annual tax position. That’s because each year you’ll have your personal allowance tax-free, and all your pensions lumps will be 25% tax free too. Only income on top of that will be taxed at your marginal rate.

Whereas if you take and spend your tax-free lump sum up front, once it’s gone all the annual income above your personal allowance will be taxed. This could push you into a higher tax bracket, meaning you pay more overall. 

The tax-free portion of your pension is capped at £268,275, even if that’s less than 25% of your total pension pot. The remaining 75% of your pension is taxed as income at your marginal rate however you take it. 

Defined benefit pensions

If you have a defined benefit (also known as final salary or career average) pension, you get paid an income for life. How much you get will be determined by how much you earned in your job and the length of time you were with the company. This income is taxed, just like earnings from a job would be. Some schemes will allow you to draw a 25% tax-free lump sum up front, but not all.

Inherited pensions

If you have inherited a pension from a loved one, the tax situation depends on various factors, including the payment method, the type of pension and the age of your loved one when they died.

You can see the rules in full on the GOV.UK website.

LISAs

While one of the aims of lifetime ISAs is to help people save for retirement, they’re not actually pensions. Instead, they sit under the ISA wrapper, which means you pay no tax when you take money from them (this is because you pay into them from post-tax income, so the money has already been taxed).

How to minimise the tax you pay on your pension

The main thing to remember when managing your retirement tax bills is to only take what you need each year. If you take too much, you could pay a higher tax rate.

Example If you draw £60,000 from your pot, £12,750 is tax-free. You pay tax at 20% on the next £32,750 and 40% on the remaining £9,730. This gives you a total tax bill of £11,432.

But if you only spend £50,000 of the money you withdraw and leave £10,000 sitting in the bank, you pay tax unnecessarily on the excess cash, and worse, it’s at the higher 40% tax rate. 

Drawing just £50,000 in this situation would cut your tax bill to £7,486, saving you £3,976.

The other thing to consider is all the different types of income you have and how to balance these. Savings and investments that are in ISAs provide tax-free income. You also have a personal savings allowance for savings not in ISAs.

That means you should structure your income carefully, considering the tax treatment of each source. So, if you wanted £20,000 each year and have a mix of ISA and pension savings, you might want to pull a bit from each to minimise your tax bill. 

An independent financial adviser (IFA) can look at your finances and develop a plan that allows you to have the income you want as tax-efficiently as possible.

Use our drawdown calculator to understand what income you’ll have in retirement