How is retirement income taxed?
Understanding how your retirement income will be taxed is an important part of developing your retirement income plan. As your employment income is taxed, the same principle applies to your pension income – with income tax deducted at your marginal rate (which is the rate of income tax your next pound would attract). Here, we’ll outline the different options available to access your pension savings and the tax implications for each.
It's important to note that tax treatment depends on your individual circumstances and may be subject to change in future. This information is based on our understanding of current taxation law and HMRC practice, which may change. If you’re unsure about which option to choose or about the tax implications we have listed some sources of help and guidance at the bottom of the page.
1. Cash lump sums
You can take part or all of your full pension pot as a cash lump sum. If you do this, normally 25% of each lump sum payment is tax free, and the remaining 75% is taxed as income. Unless we already hold a tax code for you when you take your first lump sum, you’ll pay tax on an emergency tax code on the taxable portion of the lump sum. You can find more about emergency tax codes on on the government website.
If the use of the emergency tax code means the lump sum is over-taxed, HMRC will refund the over-payment to you at the end of the tax year. Alternatively, you can contact HMRC after you receive the lump sum payment to claim an in-year refund.
If you decide to buy an annuity, you can normally take up to 25% of your pension pot as a tax free lump sum. If you choose to take this lump sum, your remaining pension funds can be used to purchase an annuity. Income tax will then be deducted from the annuity by your annuity provider, using the tax code provided by HMRC, just as an employer would do with your salary. If you elect not to take the tax free lump sum and use 100% of your pension funds to buy your annuity, all of your income will be taxed and you’ll have given up any entitlement to the tax free portion, so it’s important to seek guidance before making any decisions about your retirement options.
As annuity rates can change substantially and rapidly, there is no guarantee that when you do purchase an annuity, the rates will be favourable.
3. Flexi-access drawdown
You can normally take up to 25% of your pension pot tax free and the rest of your pot can be used for flexi-access drawdown. Flexi-access drawdown lets you keep your pension invested and choose a regular income and/or one-off cash payments. This gives you significant flexibility – you can start, stop or vary your payments to suit your needs and yearly tax position. When you take income withdrawals, your drawdown provider will deduct income tax from your income payments using the tax code provided by HMRC, just as an employer would do with a salary.
The level of income isn’tguaranteed. Drawing income wil reduce the value of your account. You may need to reduce your drawdown income in the future, in particular if investment performance isn’t sufficient or you live to a greater age than originally anticipated. It’s important to review your drawdown account value and level of income regularly.
4. Your money purchase annual allowance (MPAA)
It’s possible to continue paying into a pension plan after you access your pension pot, but the tax limits may change if you do – so you’ll need to plan your actions carefully. The MPAA can be triggered by accessing your benefits flexibly, such as taking a cash lump sum from a money purchase pension plan, taking income from flexi-access drawdown or buying a flexible lifetime annuity. Once you've triggered the MPAA, you can find out how to check if you’ve gone above the money purchase annual allowance.
5. Lifetime allowance
Before 6 April 2023, the lifetime allowance was the total amount of pension savings an individual could build up before becoming subject to a tax charge. However, the lifetime allowance is being reformed, and the first change took effect from 6 April 2023. For the 2023/24 tax year, pension benefits that exceed the lifetime allowance of £1,073,100 will no longer face a charge – instead they’ll be taxed at your marginal rate at the point when you take them, either as a lump sum or as an income.
We've outlined the tax treatment of pension and annuity income here, but remember you'll also need to pay tax on:
- Employment and self-employment earnings
- Money earned from investments
- Rental income from a property you rent out
You’re responsible for paying tax on the income you get from these additional sources – this may involve filing a self-assessment tax return with HMRC. If you have income from multiple sources on top of your pension, working with an accountant can help ensure you’re paying the correct tax.
Sources of information
For more information on how you’ll be taxed in retirement, read the government’s income tax guide.
For general information you can visit MoneyHelper who give free and impartial guidance to help make your money and pension choices clearer.
Pension Wise, a service from MoneyHelper, is a free and impartial government service offering guidance about your retirement options.
If you’d like advice based on your individual circumstances, you should consider speaking to a financial adviser. There is likely to be a charge for this. For help finding a financial adviser local to you please visit MoneyHelper.