Understanding tax on pensions

Last updated 16^th February 2024
5 min read

When you reach retirement, you may not be aware that you are required to pay tax on your pension. As the funds released to you from your pension are classed as income, you will be taxed in the same vein as your monthly wage before retirement.

There are, however, different considerations to make which may affect how tax is paid on your pension, such as taking a lump sum. You may also be taxed slightly differently depending on which type of pension you hold.

In this guide, we’ll help you to understand when it is necessary to pay tax on your pension, how it is paid and the key considerations you need to make when taking out a pension lump sum. We’ll also touch on tax relief on your pension contributions, leaving you with a clear understanding of pension tax leading up to and after retirement.

Do you need to pay tax on pensions?

Yes, there is a chance you will be taxed on your pension depending on the total amount of income you receive each tax year.

When you retire, you still hold the same personal allowance on your income as before, which is currently frozen at £12,570(www.gov.uk opens in a new tab) until 2028. In a tax year, if you do not receive income above this total, including funds from a pension, employment and property, you will not pay any tax. On the other hand, if your income exceeds your personal allowance, you will be taxed appropriately(www.gov.uk opens in a new tab).

Fortunately, if you do decide to continue working after retirement age, you will not need to pay National Insurance contributions.

Marriage and married couple's allowance

You may be eligible for a tax allowance if you are married or in a civil partnership. It is worth checking your eligibility as this could lead to a considerable amount of savings on your annual tax payment. You can do this by following the links to the government website below:

• Married Couple's Allowance(www.gov.uk opens in a new tab) – if a minimum of one person in the couple was born before 6th April 1935, couples can claim a reduction in their tax bill
• Marriage Allowance(www.gov.uk opens in a new tab) – allows one person in the couple to transfer some of their personal allowance to their husband, wife or civil partner. The lower earner must have an income below the personal allowance of that tax year to be eligible

Paying tax on state pensions

If your income is above the personal allowance threshold you will need to pay tax on your state pension.

Money in your state pension is usually released to you every four weeks and is paid in full, without any tax deductions. Instead, HMRC will automatically deduct the tax from other sources of income, such as a workplace pension or your monthly earnings.

If you do not have any other sources of income, HMRC will get in contact with you to discuss the amount owed and make arrangements to take payment.

Paying tax on defined benefit pensions

Also known as a final salary or career average pension, a defined benefit pension pays out a secure income which increases each year – this is taxable as earnings. The amount paid to you is based on the number of years you have worked for your employer and your salary, rather than money you’ve paid in yourself.

In the event of your death, some companies will continue to pay the benefit pension to a spouse, civil partner or dependant. This is taxable and is usually paid as a fixed proportion of the final pension income, calculated at the time of your death.

Find out more about defined benefit pensions(www.moneyhelper.org.uk opens in a new tab).

How much tax is paid on defined benefit pension lump sums?

Some defined benefit pensions may also provide you with a tax-free cash lump sum.

The way this is delivered to you completely depends on your individual scheme. Some schemes may offer a tax-free lump sum in addition to your normal monthly pension payments, others may offer a tax-free lump sum in exchange for a reduced pension.

Paying tax on defined contribution pensions

Defined contribution pensions, also known as ‘money purchase’ pension schemes, can be arranged by your workplace or as a private pension set up by yourself. Your pension provider will put money from the pension pot into investments which can impact the final amount you are due at retirement.

You are able to take money from your pension pot usually from the age of 55. The first 25% of your pension will be tax-free, with the remaining 75% subject to income tax.

Find out more about defined contribution pensions(www.gov.uk opens in a new tab).

How much tax is paid on defined contribution pension lump sums?

You will be able to withdraw a 25% lump sum completely tax-free. Anything more will incur the normal rates of income tax.

If you prefer, you are also able to withdraw multiple lump sums separately. In this case, 25% of each lump sum will be tax-free, with the remaining 75% of each amount taxable.

Tax relief on pension contributions

The money you pay into your private pension benefits from tax relief, worth up to 100% of your annual earnings. A portion of money which would have been paid in income tax will be redirected to your pension pot.

The amount of tax relief you receive is worked out from the rate of income tax you pay:

• Basic-rate taxpayers: 20% pension tax relief
• Higher-rate taxpayers: 40% pension tax relief
• Additional-rate taxpayers: 45% pension tax relief

You will receive the tax relief automatically if your employer deducts workplace pensions contributions from your pay before income tax or if you are a basic-rate taxpayer. In this instance, your pension provider claims tax relief and adds the funds to your pension – this is known as ‘relief at source’.

If your pension is not set up for automatic tax relief, you will be able to claim tax relief(www.gov.uk opens in a new tab) on your pension contributions.

Managing your money after retirement

If you still have more questions or you’re wondering how to budget your finances after retirement, we have a number of articles to help you manage your money after 50.

If you’d like to learn more about your pension, here are some articles that may be particularly useful:

• Pension freedoms explained: what are my choices?
• Tips to boost your pension pot
• Turning your pension into income
• Our simple guide to retirement

Sources

^[1] https://www.gov.uk/income-tax-rates(opens in a new tab)
^[2] https://www.gov.uk/married-couples-allowance(opens in a new tab)
^[3] https://www.gov.uk/marriage-allowance(opens in a new tab)
^[4] https://www.moneyhelper.org.uk/en/pensions-and-retirement/pensions-basics/defined-benefit-or-final-salary-pensions-schemes-explained(opens in a new tab)
^[5] https://www.moneyhelper.org.uk/en/pensions-and-retirement/pensions-basics/defined-contribution-pension-schemes(opens in a new tab)
^[6] https://www.gov.uk/tax-on-your-private-pension/pension-tax-relief(opens in a new tab)