When you retire, your current level of income will most likely change.
As part of this, you may be wondering: how much can a pensioner earn before paying tax? This can be important as, if you aren’t aware of your Personal Allowance or tax rate, you could end up paying a large Income Tax bill in retirement.
So, find out how much tax you may have to pay on your pension right here.
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Why might a pensioner need to pay tax?
There can be many reasons why pensioners may need to be aware of their Income Tax allowances in retirement.
Firstly, you typically need to pay Income Tax on your pension income in most circumstances, just as you have throughout your working life.
Additionally, it can also be important if you choose to work past the State Pension Age.
Historically, retirement was usually the traditional “cliff-edge” style, leaving work on Friday and waking up retired on Monday .
But now, many people opt for a more phased approach. This typically involves reducing the hours you work, perhaps working in a consultancy role or in self-employment. This can give you a good opportunity to supplement your pension wealth.
Why do I have to pay tax on my pension?
It might seem strange that you pay Income Tax on your pension income – after all, you’ve already earned that wealth.
However, a pension pot isn’t like a bank account you can just dip into. Instead, the money is held on your behalf by a pension fund. That means, when you take money from it as regular income, HM Revenue and Customs (HMRC) treat it as ordinary income.
As a result, you’re subject to the same Personal Allowance and marginal rates of Income Tax as anyone else.
How much tax do I have to pay on my pension?
You have to pay Income Tax on pension income like you would on any other kind. Thankfully, each tax year (6 April to 5 April), you have a Personal Allowance before Income Tax is due.
In the 2021/22 tax year, the Personal Allowance is £12,570, meaning you can earn this much before you need to pay Income Tax. After this, how much Income Tax you’ll pay is determined by the typical tax bands:
You’ll be taxed at 20% on earnings between £12,571 to £50,270 from pension income.
You’ll be taxed at 40% on earnings between £50,271 and £150,000 from pension income.
You will be taxed at 45% on earnings of more than £150,000 from your pension income .
Bear in mind that Income Tax and Personal Allowance thresholds may be different for Scottish residents.
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How much of my pension is tax-free?
Typically, you can access a portion of your pension tax-free. If you are a member of a defined contribution scheme, such as a typical workplace pension, you can take 25% of your pension tax-free.
So, you could simply take a quarter of your pension without paying tax.
Or you could take several smaller lump sums, with 25% of each being tax-free. The other 75% will be taxable income.
What about if I have a defined benefit pension?
If you have a defined benefit pension, sometimes known as a “final salary” scheme, you may have the option to take a tax-free lump sum along with your taxable income. The details of these schemes tend to differ, so consult your pension provider to find out more.
Are there any tax considerations when taking a pension lump sum?
While you can take 25% of your pension pot as a tax-free lump sum, you may be able to access your entire pension as a single lump sum. However, this can be a bad idea from a tax standpoint.
Any money you receive in this way will count as income for that tax year, potentially pushing you into a higher Income Tax band. This may cancel out any pension tax benefits.
Typically, this would only make sense if your pension pot is very small. If you want to be sure that you’re accessing your pension in the most tax-efficient way, seek professional advice.
Do I need to pay tax on my State Pension?
If you pay National Insurance contributions throughout your working life, you can expect to earn your full State Pension. However, income from the State Pension is potentially taxable, depending on your total annual income.
In the 2021/22 tax year, the new State Pension stands at £9,339 a year, which will rise to £9,628 in the 2022/23 tax year.
Since this is below the Personal Allowance (£12,570 in the 2021/22 tax year), if your only income is from the State Pension then you won’t need to pay Income Tax.
If your combined total income from the State Pension, private pensions, and any other income is over that limit, you’ll have to pay tax on anything above the threshold.
Bear in mind that, if you pay National Insurance contributions inconsistently throughout your career, you may receive less than the full State Pension.
Can I still work while claiming my pension?
Many people now opt for a “phased approach” to retirement, continuing to work in a reduced capacity.
Typically, you can work while drawing pension income. For example, you could continue to work as a consultant while claiming a workplace pension or the State Pension.
However, if you’re a member of a defined benefit scheme, you may not be able to work for the employer who provides you with that pension after you’ve started to claim it. Of course, you could still work somewhere else.
How will continuing to work affect the amount of tax I pay on my pension?
While continuing to work can have its benefits, it can cause potential tax issues when drawing your pension.
While your Personal Allowance doesn’t change, the extra income may push you into the next tax threshold if you take too much of your pension while continuing to work.
To avoid this, you may benefit from working with a financial advisor, who can help you draw your income tax-efficiently.
Are there any major tax issues that I need to watch out for?
If you want to enjoy your hard-earned pension wealth, you probably want to minimise the amount of tax you have to pay on it. If this is the case, there are three major issues you need to avoid:
Being subject to multiple tax codes
If you have several different sources of income while working, you may end up with multiple different tax codes.
These tell your employer and pension provider how much tax to deduct from your wages or put into your fund.
If you have multiple sources of income, such as from dividends, savings income, or one or more pensions, it’s important to let HMRC know. This is so you pay the right amount of tax for each income type.
It’s important to check these carefully and not to assume they are correct, as HMRC does sometimes make mistakes and charge too much tax when calculating your tax bill.
Overpaying tax on your pension
The first time you take a lump sum (other than the tax-free lump sum) from a defined contribution pension, you may be charged too much tax.
This is often because such payments are taxed with an emergency tax code.
This means you’re taxed as if you made the same withdrawal each month of the tax year. If you’ve overpaid tax, you may want to check the government website to see if you can claim a tax refund.
Tax on your savings
If you hold a large amount of your wealth in cash savings, the final thing to be aware of is that the way your savings are taxed doesn’t change when you reach State Pension Age.
Most banks and building societies pay savings interest without any tax. But, if you earn over a certain amount in interest, you may have to pay tax on it.
You do have a tax-free allowance for interest before tax is due called the Personal Savings Allowance. The Personal Savings Allowance is the amount of interest you can receive on your cash savings tax-free in any given tax year.
In the 2021/22 tax year, it stands at £1,000 if you’re a basic-rate taxpayer, or £500 if you’re a higher-rate taxpayer. Additional-rate taxpayers have no Personal Savings Allowance.
If you typically declare this or any other income through a self-assessment tax return, you should continue to do this after you’ve retired.
Do I need a pension review?
Your pension is one of the most important sources of wealth when it comes to retirement. So, if you want to ensure you have enough to enjoy your retirement to the fullest, you may benefit from discussing your pension options with a financial advisor.
They can help you work out your pension income tax bill, showing you how much tax you may owe in your personal circumstances.
This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.