Are you planning for retirement and don’t know how your hard-earned savings will be taxed? Don’t worry, you are not alone. Many people feel overwhelmed planning a retirement and how it will be taxed. At the same time, some people assume that retirement income is entirely tax-free.
It is important to understand how tax on pensions works in the UK, so you can plan withdrawals efficiently and avoid unexpected tax bills. This guide discusses how pensions are taxed in the UK, including workplace pensions, State Pension, and personal pensions.
How Does Tax Work on Pension Income?
In the UK, pensions are designed to provide financial security in retirement. However, there is a common misconception that retirement income is entirely tax-free. Although the UK government offers generous tax incentives, the money you withdraw in later life is still subject to tax rules. This means you pay tax on pensions.
Do You Pay Tax on Pension?
Yes, as mentioned, you pay tax on pension. Most pension income in the UK is treated as taxable income and subject to Income Tax, depending on your total annual income. It is added to any other income you may have and taxed under normal Income Tax rules.
Who Collects the Tax on Pensions?
The main authority responsible for collecting pension tax is HM Revenue and Customs (HMRC). If a person receives a workplace or personal pension, their pension provider usually deducts any Income Tax through the Pay As You Earn (PAYE) system before making payments. And, if too little or too much tax is collected, HMRC may adjust your tax code, request any tax owed, or issue a refund.
How Much Tax Will I Pay on My Pension?
The amount of tax you pay on your pension depends on your total annual income. Your annual income includes your pension and any other taxable income, such as rental income or wages.
How Much Can I Earn Tax-Free?
In most cases, you can normally take up to 25% of your pension benefits as a tax-free lump sum, subject to the applicable lump sum allowance. If your total income is below the Personal Allowance, which is £12,570, you will not pay Income Tax on pensions. However, if it is above the personal allowance, you will pay tax on the amount over the limit at the rate that applies to your income.
Let’s understand it with an example:
If your income is £10,000, there is no Income Tax. However, if you earn £15,000, then you pay income tax on £2,430 (£15,000 − £12,570).
Note: Personal allowance can be reduced or changed in certain circumstances, such as for people with very high incomes.
Income Tax Bands
To better understand tax on pensions, you need to know the income tax bands because your total income, including pensions, is taxed using standard UK rates.
Take a look at the table below that outlines the current standard UK rates and allowance.
| Band | Taxable Income | Tax Rate |
| Personal Allowance | Up to £12,570 | 0% (tax-free) |
| Basic rate | £12,571 to £50,270 | 20% |
| Higher rate | £50,271 to £125,140 | 40% |
| Additional rate | over £125,140 | 45% |
If your taxable income is over £125,140, then you do not get a Personal Allowance. Also, if your pension income pushes your total earnings above these thresholds, the excess is taxed accordingly.
Do You Get Taxed on Pension?
Yes, pension income is taxable in the UK. It is subject to the same tax rules and rates as a regular salary. However, you only pay tax on pensions if your total annual income exceeds your Personal Allowance. Also, the amount of tax you pay depends on your annual income, including your pension, State Pension, salary, and any other taxable income.
State Pension and Tax
Your State Pension is taxable income, but tax is not deducted before payment. Instead, it is paid gross (without tax taken off) and is taxed through other income sources or through a tax code adjustment.
Typically, you will not pay tax on pensions if the State Pension is your only income and it stays below the Personal Allowance.
Workplace and Private Pensions
Private pensions and workplace pensions are taxed when you withdraw money. Most people can currently access private pensions from age 55, rising to age 57 from April 2028 unless protected pension age rules apply. When you withdraw funds, 25% is tax-free, whereas the remaining 75% is taxed as income. This applies whether you take it as lump sums, flexible drawdowns, or regular pension payments (annuity or income withdrawals).
Defined Benefit Pensions
A defined benefit pension is different because they are not earnings or savings but government support payments. It is a workplace pension that gives you a guaranteed income for life after you retire. The pension is paid monthly and often increases with inflation.
What If I Take a Lump Sum From My Pension?
In the UK, most pension schemes allow you to take up to 25% of your pension tax-free. However, the remaining amount is subject to Income Tax. Withdrawing a large lump sum could increase your total income for the year. Also, it can move you into a higher Income Tax band, meaning you may pay more tax on pensions.
In some cases, the wrong amount of tax may be taken at first, and this is usually corrected later by HM Revenue and Customs (HMRC).
Emergency Tax on Lump Sums
If you take a pension lump sum, your provider can use an emergency or a temporary tax code for the payment. And when a pension provider does that, it may look like you earn more than you really do over the year. As a result, you may pay too much tax on pensions. However, you can claim back any overpaid tax later.
Do I Pay Tax on My Savings in the UK?
You do not pay tax on the money held in savings accounts. However, you may pay tax on the interest your savings earn if it exceeds your Personal Savings Allowance.
You can earn some interest tax-free because of the Personal Savings Allowance, depending on your total income. If the interest goes above your allowance, you may have to pay tax on the additional amount.
How Do I Pay Tax on Pensions?
Usually, you do not pay tax on pensions yourself. Your pension is taxed automatically before you receive it. Pension providers in the UK use the Pay As You Earn (PAYE) system to deduct Income Tax and send it to HMRC.
PAYE is also used for wages. If too much or too little tax is taken, don’t worry because HMRC may adjust your tax code or ask you to pay more or give you a refund.
How to Avoid Paying Tax on Your Pension?
You cannot completely avoid tax where it is legally due. Still, many UK residents may be thinking about how to avoid paying tax on pensions. You must know that you cannot avoid paying tax on your pension. However, you can reduce the amount of tax you pay. Here is how you can reduce it:
- You can take up to 25% of your pension savings tax-free.
- Stay under the Personal Allowance threshold
- Take smaller withdrawals over several tax years instead of one large amount. This can help keep you in a lower Income Tax band.
- If you are still making eligible pension contributions, you may qualify for pension tax relief on those contributions.
Consider your total yearly income before taking money from your pension because this can affect how much tax you may pay.
When you take taxable pension income, it may trigger the Money Purchase Annual Allowance (MPAA). This reduces how much you can contribute tax-efficiently to pensions in future.
How to Reclaim Overpaid Tax?
If you pay too much tax on your pension, you can usually reclaim the overpayment. Sometimes, HMRC automatically refunds any overpaid tax after the end of the tax year. If it is not issued automatically, you can make a claim through the official HMRC website using the appropriate form.
The Bottom Line
Tax on pensions is based on standard Income Tax rules. This means your pension income is taxed alongside any other earnings. Keep in mind that 25% of most pension withdrawals is tax-free, but the remaining amount is generally subject to tax depending on your total income.
Although you cannot avoid paying tax on your pension, you can reduce how much tax you pay in retirement with proper planning. Make the most of your pension savings by understanding how rules set by HMRC apply to your situation. This can also help you avoid unnecessary tax burdens.
How Accotax Can Help?
Understanding pension tax rules can get complicated, and that’s why you need a tax expert. At Accotax, we have a team of qualified accountants who can help you structure your retirement income in a tax-efficient way.
Speak to our qualified accountant today to create a tax-efficient pension withdrawal plan. Get an instant quote now!
Disclaimer: The information about How Much is Tax on Pension and How Can You Avoid it? provided in this article including text and graphics. It does not intend to disregard any of the professional advice.
