Pensions are a tax-efficient way to save for the long term. That’s because when you pay into a pension, the government gives you tax relief on your contributions. This means some of the money that you would have paid in tax can instead go towards your savings for the future.
However, when you come to take money out of your retirement savings, you’ll likely be taxed on some of this income. This depends on how much money you’ve saved and how you want to take it. Understanding the rules can make sure you don’t get caught out with a tax charge you weren’t expecting. Here are some basics to get you started.
This information is based on our understanding of current taxation law and HMRC practice, which may change. The value of any tax relief will depend on individual circumstances.
How much tax will I pay on my pension withdrawals?
Any income you receive from a pension is treated like income you’d get from a job. You pay income tax on your pension withdrawals if your total annual ‘non-savings, non-dividend’ income is more than your personal allowance – the amount every person is entitled to earn before they start paying income tax. For the 2023/24 tax year the standard personal allowance is £12,570.1
Your total annual non-savings, non-dividend income could include the State Pension, a private person or workplace pension, earnings from a job or self-employment, income from a rental property and any taxable benefits.
You’ll pay basic rate income tax at 20% on total annual non-savings, non-dividend income between £12,570 and £50,270. Above this threshold you pay a higher rate of 40% – and on income above £125,140, you’ll pay tax at 45%.1 Also, if your total income is greater than £100,000, then your personal allowance will be reduced by £1 for every £2 of income you earn over £100,000.
If you live in Scotland the tax rates and bands are slightly different – find out more on the government’s webpage.
How much tax will I pay on a lump sum withdrawal?
You’ll usually be able to take up to 25% of your pension pot as a tax-free lump sum. You can do this for multiple pension pots you might have – but the maximum amount of tax-free cash you can withdraw from your pensions in your lifetime is £268,275.2 The only exception to this would be if you’d previously applied for protection and were entitled to a higher tax-free lump sum before 6 April 2023.
Once you have taken the maximum of tax-free lump sum, any lump sums you take out of your pension pot will be classed as part of your income for that year. This means your income may end up in a higher tax band, and you’d pay tax at the higher rate of 40% or more.
Will changes to the lifetime allowance affect the tax I pay?
The lifetime allowance (LTA) will be abolished from 6 April 2024, but some changes have already taken place. The LTA is the total you can save across pension pots in your lifetime before paying additional tax charges when you come to withdraw any money. This charge could be up to 55%, depending on how you chose to take the income. However, the government has scrapped this tax charge as of 6 April 2023.2 Instead, you’ll pay income tax at the applicable rate calculated using the government’s tax bands. Remember that tax bands and rates in Scotland will differ.
Unless you were close to exceeding the LTA, or have already exceeded the LTA, the changes are unlikely to affect you. But if you do have a lot saved, it means you can continue to save into your pension without facing an additional tax charge when you come to take an income from your savings.
Here's a case study to bring it to life
Alfred is 68 and lives in Birmingham. He’s just retired from his job at a housing association where he earned £42,000 a year. He has a single pension pot worth £600,000.
- Alfred wants to take advantage of the 25% tax-free lump sum rule which will allow him to withdraw £150,000 without paying tax.
- Of the remaining £450,000 he has in his pension pot, Alfred would like to use income drawdown to give himself a regular income of £15,000 a year.
- He also receives £16,000 in total a year from the State Pension and income from a small piece of land he owns, meaning his total annual income is £31,000 (£15,000 + £16,000).
- Alfred’s personal allowance means he can receive up to £12,570 each tax year before he has to pay income tax. This means the total income Alfred is taxed on will be £18,430 (£31,000 - £12,570).
- As Alfred pays a 20% basic rate of tax, this means he’ll pay 20% tax on the £18,430 of non savings non dividend income he receives each year above his personal allowance. This equals £3,686.
Improve your pensions know-how
Pensions can be a useful tool to help you save for a future beyond work. Understanding how your pension is taxed could help you to create a more realistic retirement plan. While the rules can seem complex, remember there are free resources available to help you, such as the government’s MoneyHelper website.
To get more of your pensions questions answered, read our guide on: How to feel confident with your pension.