- 25% of pension savings are typically tax free but watch out for emergency tax codes on initial withdrawals
- Pensions are an incredibly tax efficient way to save for your future. But what do you need to know about making sure your hard-earned retirement savings are working as hard as possible for you when you access them?
Dean Butler, Managing Director for Customer at Standard Life, part of Phoenix Group, comments: “It’s been said that the only certainties in life are death and taxes – sadly, there’s some truth in this as tax doesn’t go away when you retire. Many people understandably don’t think about how much tax they’ll need to pay from their pension income, however it’s important to bear in mind especially when it comes to the critical moment of accessing pension savings. Withdrawals are a complex area and as result I’d always recommend you take advice if at all possible, use the government’s free Pension Wise guidance service or speak to your provider for the more complex questions.”
How much tax will I pay?
“The ultimate question. How much tax you’ll pay when you withdraw money from your pension plan depends on various things – including the way you take the money. There are several different ways you can withdraw your pension savings, and these can mean different ways of being taxed.
“It’s important to know how your withdrawals are taxed so you don’t end up paying more than you need to in any one tax year. Since money you take from your pension plans is classed as income, taking too much can push you into a higher tax band, especially if you’re taking large lump sums or your whole pot. Therefore it’s important to work out the income you need and to consider if it’s more beneficial to leave the rest within your pension.”
25% is typically tax free
“You can normally access your pension savings from age 55 (rising to 57 from 6 April 2028) and take 25% of any pension pot as a tax-free lump sum. The remaining 75% will usually be taxed in the same way as income you’d get from working so the amount you pay will depend on what tax band you’re in.
“Remember that your tax band is based on your total annual income. This can include money taken from your pension savings; other savings and investments; your State Pension; earnings from work; and certain benefits. You can check your income tax band on the government’s website.
“You’ll have a personal allowance, which is the amount of annual income you can have that you aren’t taxed on. For most, this is £12,570 in the current tax year.”
How much tax will I pay on a pension in drawdown or an annuity income?
“When you take a flexible income (drawdown) or an annuity income, how much tax you pay depends on your tax band. If you choose drawdown, you can set up a regular income, which you can start, stop, or change whenever you want. You can also make one-off withdrawals. By comparison an annuity provides a regular income that will only vary if you’ve chosen options like inflation protection.
“If you have set up a regular income that gives you £18,000 a year and this is your only income, you would fall into the basic-rate tax band, so you’d pay tax on your pension withdrawals at a rate of 20%. However, if you have a personal allowance of £12,570, you’ll pay the 20% tax on only £5,430, rather than £18,000. So, you’d pay £1,086 in tax, which would normally be deducted automatically by your pension provider.
“You might be subject to emergency tax at first, meaning your pension provider might deduct more tax than you actually owe from the first payment they make to you. You’ll need to claim any tax you’ve overpaid back from the government. After this, the government will update your provider with your correct tax details.”
How much tax will I pay on a pension lump sum?
“If you take more than 25% of your pot, you’ll pay tax on lump sums based on your tax band.
“When you first withdraw a taxable lump sum, you’ll probably be put on an emergency tax code, meaning the government treats the amount you’re taking as though that’s what you’ll take every month. So, if you take £10,000, your pension provider may automatically deduct tax as though your annual income is £120,000. In this situation, you can fill out a P55 form to reclaim overpaid tax. Once the government has given your provider up-to-date tax details for you, you should be taxed at your normal income tax rate for future withdrawals.”
How much tax will I pay if I take my full pension pot?
“If you take your full pension pot in one go, the usual rules apply. 25% will normally be tax-free, and depending on the size of the remaining pot it will be taxed at your marginal tax rate So, if you’re taking all your pot in one go you could put yourself into a higher tax band and have a large tax bill for that year as the more money you take, the more there is to pay tax on. You’d be surprised how many people reaching retirement initially ask to take their full pension before often realising this could be a really inefficient way of withdrawing money it has taken a lifetime to build.
“If you have a personal pension pot worth less than £10,000, you might be able to withdraw it in one go as a ‘small pot lump sum’. There are slightly different rules for these, but when it comes to tax, you’ll still get 25% of your pot tax-free, and the rest will still be taxed as income.
“If you take a small pot lump sum you’ll usually be taxed at the basic rate of income tax (20%). You might not be in the basic-rate tax band, though, so 20% could be more or less than what you actually owe. Again, if you end up overpaying, you can claim that tax back.”
Do I pay tax on my State Pension?
“Your State Pension is taxable, but tax normally won’t be taken from your State Pension itself.
“The full new State Pension is just over £10,600 in the current tax year, which is less than the standard personal allowance of £12,570, the income on which you don’t pay tax. So, this won’t be taxed, but it does count as part of your total annual income.
“Imagine you get the full new State Pension, then take £10,000 as a flexible income from your pension plan in a tax year. Your total income would be over the personal allowance, and you’d pay tax at a rate of 20% on this additional income. This would usually be deducted from withdrawals from your pension plan, rather than your State Pension.”
About Standard Life
- Standard Life is a brand that has been trusted to look after peoples' life savings for nearly 200 years
- Today it proudly serves millions of customers who come to Standard Life directly, through advisers and through their employers' pension scheme.
- Standard Life is part of Phoenix Group, the largest long-term savings and retirement business in the UK. We're proud to be building on nearly 200 years of Standard Life heritage together
- Our products include a variety of Pensions, Bonds and Retirement options to suit people's needs, helping our customers to invest and save for their future. We're proud to offer a leading range of sustainable and responsible investment options.
- We support our customers on their journey to and through retirement with comprehensive, easy-to-understand guidance so they can invest in the right way for their needs, and plan a future they feel confident about
- The value of investments can go down as well as up and may be worth less than originally invested.