How is Pension Income Taxed?

Income during retirement is taxed in the same way as when you are working. The amount of tax that you pay is dependent on your Personal Tax Allowance; this is the amount of money you can earn in a financial year before paying any tax. At the time of writing this post, the standard personal tax allowance in the UK is £12,500. In this post, we’ll be looking at why pension income is taxed, how much of your fund is exempt from income tax, and finally how the type of income option you decide to take can affect your tax position.  

Wait, am I paying tax twice? 

It is a common misconception that having tax deducted from your pension income means that you have paid tax twice; once during employment and then again in retirement, this is incorrect. When you receive income through your employer, your pension contribution is taken from your pay before tax is calculated, meaning that if you earn £2000 per month, and your pension contribution is 3% then the amount of tax you pay is calculated on £1940, the amount remaining after you have made your pension contribution.  

Therefore, when you take an income from a pension either while you are still in employment, self-employed, or when you have retired, that income contributes to your annual income and any income over your Personal Tax Allowance is taxed in line with the relevant tax bracket.  

Tax-free Lump Sum

The good news is that you can usually take up to 25% of your pension savings as a tax-free lump sum, regardless of whether you plan to take a regular income from your fund straight away. For example, it may be that you are approaching 55-year-old, have no plans to retire yet or take an income, but you would like to access some of your £150,000 pension savings to make home improvements. One option would be to take your £37,500 tax-free lump sum and then put the remainder into a Flexible-Access Drawdown plan, taking no income and leaving the fund invested with the view to grow it further. It is important to remember that, as with any investment, there are no guarantees and the overall fund value could decrease as well as increase. 

Annuities 

An annuity is probably the most straightforward form of income to calculate tax from; this is because it commonly provides a guaranteed fixed income, like a salary during employment. When setting up your annuity you will be advised of what your annual income will be; this is with any other income which could include:  

• Salary, if still in employment.  
• State pension. 

• Any other private pensions.  
• Rental income from property assets. 
• Income from Investments, Shares etc.    

Your total annual income and anything over your Personal Tax Allowance becomes taxable income and will be taxed at the applicable rate.  

Drawdown 

Although based on the same tax rules, it can be slightly harder to calculate the tax payable from a Flexible-Access Drawdown plan; this is because the annual income may not be a set amount and could change throughout the year depending on how you choose to draw from the plan. For example, you may have chosen not to take a regular income but instead draw from it as required.  

Regardless, the income you take from the plan in any given year makes up part of your annual income, and anything above your Personal Tax Allowance is taxable at the applicable rate. It is important to note that taking a single large withdrawal from your fund could push you into a higher tax bracket for that year, as such it is important to receive ongoing financial advice when in Drawdown to assist in you making tax-efficient decisions and planning. The team at My Pension Expert provide this to our clients through an annual review, although your Independent Financial Adviser is available to you all year round.  

If you have any questions or concerns about how your pension income will be taxed feel free to speak to one of our Retirement Specialists who will be happy to answer your questions or arrange a discussion with one of our friendly Independent Financial Advisers.