Tax on your pension benefits

We talk about the tax benefits you get when building up your workplace pension on our tax advantages page, but it's important to remember that you may also enjoy some attractive tax advantages when you want to start taking money out as well.

It’s important to be careful how you take pension benefits or you could be landed with an unnecessary tax bill. If you need advice about tax or any other financial decisions, please speak to a financial adviser. If don't already have one, you can find an adviser close to where you live or work at unbiased.co.uk(Opens new window)

Our retirement planning website(Opens new window) has lots of information about how tax affects your options in retirement.

Taking your tax-free 25% lump sum

When you’re eligible to start taking money out of your workplace pension (usually from age 55), up to 25% of your pension pot can be taken out as tax-free cash.

You can choose to take this tax-free cash all in one go or gradually:

If you take money out of your existing pension pot, it’s classified as an uncrystallised funds pension lump sum (UFPLS). 

With an UFPLS, normally 75% of every withdrawal you make is taxable and 25% is tax-free. If you make a sizeable withdrawal, that 75% taxable portion could even push you into a higher tax rate than you usually pay. 

So it’s very important to calculate what tax liability you could have before you take out any money directly from your pension account.

If you transfer your accrued pension pot into a flexi-access drawdown plan, you can have more flexibility. You can:

  • take the whole 25% tax-free lump sum upfront and defer the taxable income (e.g. until you’re in a lower tax bracket); or
  • take a mix of tax-free lump sum and taxable income when and how you wish.

In other words, it’s easier to plan to take money out when your tax situation is most favourable.

If you want to use your pension fund to buy an annuity, you can still take out 25% as a tax-free lump sum. The rest can be used to buy an annuity income that's taxable at your highest marginal rate of tax.

If you’re not sure of the optimal way to take your pension benefits for your tax circumstances, please seek financial advice. If you’re 50 or over you can also contact the government service Pension Wise(Opens new window)(Opens new window).

Taking your taxable income

As we’ve said above, 75% of the value of your pension pot is treated just like earned income. It’s subject to income tax at your highest marginal rate of tax, which is payable as and when you take money out. Tax is usually paid using the ‘pay as you earn’ (PAYE) system via your pension or drawdown provider. Any over- or under-payment can be reclaimed using your self-assessment tax return.

Of course, if your pension income plus any other taxable income you earn falls below your annual ‘personal allowance’, there won’t be any tax to pay. But don’t assume this will be the case. Assess the level of income you want to take out of your pension (plus any other taxable income you’ll receive, such as the State Pension) against current tax allowances. Visit the Government website(Opens new window) for current personal allowances and tax rates here. 

Tax on what you leave on death

Thanks to the new pension freedoms introduced in 2015, passing on your pension to your heirs and dependants has become more attractive in tax terms. If you haven’t used up your pension pot before you die, its tax treatment will depend on your age when you die and what you did with it before death:

If you die before age 75

If you die before age 75 and haven’t started taking pension benefits or you’ve moved to a flexi-access drawdown arrangement, the value of your pension can generally be passed on free of tax, provided you haven’t exceeded the lifetime allowance and it's paid within two years. 

After the end of a two year period following death, any payment is classed as an uncrystallised funds lump sum death benefit and will be subject to the Special Lump Sum Death Benefit Charge(Opens new window).

If you have an annuity, any death benefits in effect have the same tax benefits as flexi-access drawdown, and other types of pensions which haven't been used to buy an annuity. Tax might or might not be payable depending on when the annuity holder dies - generally, the death benefits are tax-free if death occurs before age 75, and subject to tax if death occurs after age 75 subject to the terms and conditions of the annuity policy.

If you die after age 75

If you die from age 75 onwards and haven’t started taking pension benefits or you’ve moved to a flexi-access drawdown arrangement, the value of your pension can generally be passed to any beneficiaries and taxed at their own marginal rate of income tax. These tax rates will differ if the payment is not going to an inidvidual, for example, a trustee or company director.

Inheritance tax is only liable on any cash that has been withdrawn from a pension but is unspent on death – see table below.

Caption
What tax do your beneficiaries pay?
What’s inherited You die before age 75 You die age 75 or after
Money still in your pension account No tax - if paid within two years* Income tax at their own marginal rate
Flexi-access drawdown No tax - if paid within two years* Income tax at their own marginal rate
Joint, guaranteed or capital protected annuity No tax Income tax at their own marginal rate
*Subject to lifetime allowance

Also see