Do You Pay Tax on Your Pension?

Pensions allow you to build a pot of savings designed to support you during retirement. But one thing you may be wondering is: do you pay tax on your pension?

While they are relatively tax-efficient, there are some complex tax rules involved with pensions. So, continue reading my guide to discover everything you need to know about tax on pensions.

Also consider: My guide on how to transfer a pension

How much tax will you pay on pensions?

When you eventually retire, you’ll still typically be required to pay Income Tax on any income over your Personal Allowance. That means your pension income could be subject to tax.

This is because your pension isn’t a bank account – you don’t “own” the money held in your pension pot until you reach the required age.

So, when you do eventually reach retirement age, your pension is taken as an income, meaning it’s typically subject to Income Tax. This is the case for both personal pensions and the State Pension.

In the 2022/23 tax year, the Income Tax bands in the UK are as follows:

Bear in mind that the threshold at which the additional-rate tax band kicks in will be reduced from April 2023, down to £125,140.

Defined contribution pensions

One of the most common types of pension these days is a defined contribution scheme, or a “DC pension”, as they’re commonly referred to.

The value of your defined contribution pension depends on how much you contributed to it in total. This includes your own contributions, as well as employer contributions, tax relief, and any investment returns generated.

If you have a DC pension, you can typically take the first 25% as a tax-free lump sum. The rest of your pension could then be subject to Income Tax.

Tax on DC pension withdrawals

You can usually start withdrawing funds from a DC pension when you reach the normal minimum pension age (NMPA), standing at 55 as of the 2022/23 tax year. This is set to rise to 57 in 2028.

While you can take the first 25% of your pot as a tax-free lump sum, the rest may be subject to Income Tax at your marginal rate.

You typically have several different options for withdrawing the rest of your DC pot. Continue reading my guide to discover the different ways you can withdraw your pension, and how you’ll be taxed.

Also consider: Can I withdraw my pension before 55?

One or more lump sums

As I have previously mentioned, you can typically take the first 25% of your pension savings as a tax-free lump sum.

You aren’t limited to a single pension lump sum payment either, as you can take as many as you like.

Though, you should keep in mind that only the first 25% of your pension pot will be free from Income Tax. So, if you take the remaining 75% of your pot as a single lump sum, you’ll have to pay Income Tax on the entire remaining amount.

Pension drawdown

Pension drawdown allows you to take the first 25% of your pension pot as tax-free cash, and you can then leave the rest invested with your pension provider.

When your money is left invested, it could continue to grow in the markets. Then, you can draw the remainder of your pension as income over a set period of time. Again, only the first 25% you take will be free from Income Tax.

This form of pension withdrawal is sometimes referred to as “flexi-access drawdown”.

See also: My guide to the Best Performing Drawdown Pensions

Buy an annuity

An annuity differs greatly from other forms of pension withdrawal, as it is essentially an insurance product.

If you would like to take your pension in the form of an annuity, you can use all or part of your pension savings to buy one from an annuity provider.

The provider will then pay you a guaranteed income based on factors such as the size of your pension pot and your age.

An annuity can be useful if you’re worried about having to rely on the value of investments in your pension during retirement.

Annuity income will be subject to Income Tax in the same way as pension income.

Defined benefit pensions

Meanwhile, a defined benefit pension – also referred to as a “DB pension” or a “final salary pension” – allows you to make contributions until you reach the retirement age set by your employer/the scheme. This is often 60 or 65, but could be as low as 55.

The income you receive from a DB pension normally depends on factors including the amount of time you worked for a company, and your final salary when you stopped working for them. This is where the name “final salary pension” comes from.

It’s worth noting that DB pensions are relatively uncommon these days, and are typically only available to those who work in the public sector.

Much like a DC pension, you can draw the first 25% of your pot as a tax-free lump sum. In some cases, you’ll be able to take your entire pension as a cash lump sum, but it will typically be paid as a guaranteed income for the rest of your life.

Either way, any value above the 25% tax-free lump sum could be subject to Income Tax.

Pension contributions and tax

Pensions are considered to be highly tax-efficient in general, largely down to the way you’re taxed on your contributions.

Below I have explained exactly how you will be taxed on contributions.

Tax relief on pension contributions

Firstly, any contributions you make into your pension are typically free from Income Tax and Capital Gains Tax (CGT).

You’re also entitled to tax relief when you make contributions, in which the government “tops up” your contributions depending on how much you deposit to your fund.

You typically receive tax relief on any contributions made below the pension Annual Allowance – I’ve explained this in further detail below.

The tax relief you’re entitled to depends on your Income Tax bracket. Everyone in the UK is entitled to basic-rate tax relief of 20%; so for example, if you made an £800 contribution, the government would give you an additional £200 on top of this.

This means that a £1,000 contribution for a basic-rate taxpayer technically only “costs” you £800.

If you’re a higher- or additional-rate taxpayer, you can claim even more tax relief.

For example, higher-rate taxpayers can claim an extra 20% on contributions, while additional-rate taxpayers can claim an extra 25%.

It’s worth keeping in mind that you must claim this extra tax relief through your self-assessment tax return.

The Annual Allowance

The Annual Allowance is essentially the limit that the government sets on annual tax-efficient pension contributions.

As of the 2022/23 tax year, this allowance stands at £40,000 or 100% of your earnings, whichever is lower. If you reach this allowance, you are free to continue making contributions into your pot, though you won’t receive tax relief on them and you’ll typically be taxed on them.

Contributing to your pension after you start drawing it

When you eventually do go to flexibly draw your pension, you can sometimes still make contributions if you retain some earnings, though you are typically limited in doing so.

If you are flexibly drawing from your DC pension, and you wish to make further contributions from your earnings, you are restricted by the Money Purchase Annual Allowance (MPAA). This limits your tax-efficient contributions to £4,000. Of course, you can contribute more than £4,000, though your deposits will typically be subject to Income Tax.

It’s worth keeping in mind that the MPAA can become quite complex, so you should ideally speak with a financial adviser to discuss how to make it work for you.

The Lifetime Allowance

Meanwhile, the Lifetime Allowance (LTA) is the total limit on tax-efficient pension contributions that can be made over the span of your entire life.

As of the 2022/23 tax year, this allowance stands at £1,073,100 and counts across all pensions you hold.

This allowance doesn’t just cover your contributions, but all the value in your fund (or funds). This means that your LTA covers:

• All contributions, from yourself and/or your employer
• Any tax relief received
• The growth of your investments.

If you do exceed your LTA, you’ll typically pay tax when you come to withdraw your savings in retirement. The rate of this will be:

• 55% on a lump sum that exceeds the LTA
• 25% on income drawn that exceeds your LTA, on top of any Income Tax you’ve paid at your marginal rate.

Do you pay taxes on the UK State Pension?

You are also entitled to the State Pension when you reach State Pension Age – 66 in 2022/23, although set to rise to 67 in 2028.

You must pay National Insurance for at least 10 years to receive any State Pension, and at least 35 years to receive the full amount.

Typically, you will be required to pay a tax bill on your State Pension, though the amount you pay will depend on your total annual income.

For example, your standard Personal Allowance for the 2022/23 tax year is £12,570, while the total amount you can receive from the State Pension in the same tax year is £9,627.80.

So, if you are relying solely on the State Pension, you won’t pay any Income Tax, as the amount you receive is below the Personal Allowance.

Though, if you are relying on multiple sources of taxable income during retirement, such as from your State Pension and from a personal pension, you could be pushed above the Personal Allowance and may need to pay a tax bill.

So, say you receive the full new State Pension, and hold an annuity that pays £8,000 a year.

Your total income for the entire year would be £17,627.80. Subtracted from your Personal Allowance, you are left with £5,057.80 to be taxed at 20%, which is £1,011.56.

Which type of pension is the most tax-efficient?

The most tax-efficient form of pension typically depends on your personal circumstances at the time, such as your desired lifestyle during retirement and your marginal rate of Income Tax.

Pension drawdown typically gives you greater control over your retirement savings, as you can vary your income and manage your tax liability each year.

Meanwhile, annuity income or taking a lump sum will give you less flexibility to control your income.

Can you avoid paying tax on your pension?

The famous quote “nothing is certain but death and taxes” still rings true with pensions. Though, there are several steps you can take to be as tax-efficient as possible.

For example, to make your pension tax-efficient, you could aim to only take the amount you realistically need each tax year.

Unlike taking a salary, it may not be advantageous to have more income than you need so you don’t have to pay too much tax. That’s why it could be better for you to leave your money in your pension until you’re sure you’ll need it.

Pension tax FAQs

Please note

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.