As you probably know, retirement typically brings with it a lot of changes in your life and one of the biggest ones is your income.
This may leave you with a lot of questions. One of the most obvious things that you may be wondering is how much you can earn as a pensioner before paying tax. This can be very important as if you aren’t aware of your allowances, you could end up paying a large tax bill.
If you want to know how much tax you may have to pay on your pension, read on for everything you may need to know.
You might also like to read: Best Pension Providers in the UK
Why might a pensioner need to pay tax?
While you may not initially think it, there can be many reasons why a pensioner may need to be aware of their income allowances in retirement.
The first is that you typically need to pay tax on your pension income in most circumstances. However, it can also be important if you choose to work past the State Pension Age.
In the past, the most common form of retirement was the traditional “cliff-edge” style, in which you left work on Friday and woke up on Monday as a “retired” person. While this has obvious benefits, in recent years many people have opted for a more phased approach.
This typically involves slowly reducing the hours that you work or perhaps working in a consultancy role. 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 why you would have to pay Income Tax when you take benefits from your pension – after all, you’ve already earned that wealth.
The reason for this is that your pension pot isn’t like a bank account that you can just dip into. Instead, the money is being held on your behalf by a pension fund. Because of this, when you take money out of it as regular income, HM Revenue and Customs (HMRC) treat it as ordinary income.
How much tax do I have to pay on my pension?
Essentially, you have to pay 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 for which you don’t have to pay any Income Tax.
In the 2021/22 tax year, this stands at £12,570, meaning you can earn this much before you need to pay tax. After this point, your income is taxed according to typical tax bands:
If you earn between £12,571 to £50,270 from pension income, you will be taxed at 20% on this amount.
If you earn between £50,271 to £150,000 from pension income, you will be taxed at 40% on this amount.
If you earn more than £150,000 from your pension income, you will be taxed at 45% on any amount over this limit.
Please bear in mind, however, that if you live in Scotland then these thresholds may be different.
How much of my pension is tax-free?
You’ll no doubt be pleased to hear that a large portion of your pension can be accessed 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.
There are several ways you can take advantage of this, such as simply taking a quarter of your pension in a single tax-free lump sum. However, it is also possible to take several smaller lump sums, with 25% of each of these being tax-free. Of course, the other 75% of your pension income will be taxed normally.
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 also have the option to take a tax-free lump sum along with your taxable income. Since the details of these schemes tend to differ, you may want to consult your pension provider to find out more.
Are there any tax considerations when taking a pension lump sum?
As you might be aware, 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, while this might seem tempting, it can often be a bad idea from a tax standpoint.
This is because any money you receive in this way will count as income for that tax year, which can potentially push you into a higher tax band. This may mean that the action cancels out any tax benefits from having that wealth in a pension.
Typically, the only time that this would make sense is if a pension pot is very small. Of course, if you want to be able to access your pension with confidence that you’re doing so in the most tax-efficient way possible, you may benefit from seeking professional advice.
Do I need to pay tax on my State Pension?
If you work hard all your life and pay National Insurance contributions throughout that time, you can expect to earn your State Pension, though you might be wondering if you have to pay tax on it. To put it simply, income from this is potentially taxable but that depends on your total annual income.
As you may know, in the 2021/22 tax year, the 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 annual 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 a penny of Income Tax.
Of course, if you have income from private pensions that mean your total income is over that limit, you will have to pay tax on anything above the threshold.
Can I still work while claiming my pension?
As I mentioned earlier, in recent years many people are increasingly opting for a “phased approach” to retirement, in which they continue to work in a reduced capacity.
If you want to do this, you’ll be pleased to know that you can typically work while drawing pension income. For example, you could continue to work as a consultant while claiming from a workplace pension or even from the State Pension.
However, if you are 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’s important to be aware that it can cause potential tax issues when it comes to drawing your pension.
This is because, while your Personal Allowance doesn’t change, the extra income may push you over the next tax threshold if you take too much of your pension while continuing to work.
If you want to avoid the prospect of this happening, you may benefit from working with a financial advisor who can help you draw your income in the most tax-efficient way.
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 that you have to pay on it. If this is the case, there are three major issues that 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 several different tax codes.
Essentially, these tell your employer and pension provider how much tax they need to deduct from your wages to 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.
If you want to be able to retire with confidence, it’s important to check these carefully and not to assume that they are correct, as HMRC does sometimes make mistakes.
Overpaying tax on your pension
The first time that 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.
What this means is that you’re taxed as if you made the same withdrawal each month of the tax year. If you have overpaid in tax, you may want to check the government website to see if you may be able to claim a tax refund.
Tax on your savings
As you probably know, 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.
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 the State Pension Age.
As you may know, most banks and building societies pay savings interest without any tax, but if you go over your allowance due to other sources of income, you may have to pay it on your savings income.
If you typically declare this 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. After a life of hard work, you deserve to be able to enjoy this period to the fullest.
Furthermore, it may have to last you for several decades so it’s important that your pension can provide you with a sustainable income.
If you want to ensure that you have enough to enjoy your retirement to the fullest, you may benefit from discussing your pension options with a financial advisor.
Simon is an independent financial advisor with over 20 years experience in pension planning and wealth management. He’s a regular contributor on Investing Reviews and is often cited in the mainstream media with his views and comments on the state of the economy and the effects on UK investors.