So, you’ve been saving into your pension, and now you’re ready to start taking an income from it.
Here’s how pension tax might affect you.
Tax-Free Lump Sums
Everyone has a tax-free lump sum allowance.
This is usually up to 25% of your pension pot, which you can take tax-free. This is known as your tax-free lump sum. The remaining 75% of your pension will be subject to income tax at your marginal rate when you withdraw it.
There is also a limit to the amount you can take from your pension as tax-free lump sums. This is currently £268,275 and applies across all the pensions you hold. Once you reach this amount, any lump sum you take will be subject to income tax at your marginal rate.
Imagine you have a pension pot worth £200,000. You can take up to £50,000 as a tax-free lump sum. The remaining £150,000 can be used to provide an income, which will be subject to income tax at your marginal rate in the tax year you take it.
Multiple Lump Sums
You don't have to take your tax-free lump sum in one go. You can take multiple lump sums over time. This means that each time, the first 25% of each withdrawal is tax-free.
Let’s say at the start of the year you decide to take £20,000 from your pension pot. £5,000 of this amount will be tax-free. You don’t have to take the remaining the £15,000 straight away, as your pension provider will keep this in a separate pot for you. This will be taxed when you decide to take it, whether you take it in one go. Or, if you take small amounts as regular income when you need it.
Paying tax on inherited pensions
In the 2024 Autumn Budget, the Chancellor announced that from 6th April 2027 pensions will become part of your estate and subject to inheritance tax (IHT) when you die. This means that if your whole estate exceeds the nil-rate band of £325,000, plus the residential nil-rate band of £175,000, the remaining amount could be subject to IHT at 40%.
If you pass your whole estate onto your spouse or civil partner, they won’t be charged IHT. They can also take any unused IHT allowance and add it to their own. This means that a couple could have an estate allowance of £1million.
If you pass away at age 74, your beneficiaries can inherit the entire amount and not pay income tax on any withdrawals they make from it. They will still have to pay IHT.
If you die after the age of 75, your beneficiaries will have to pay both IHT as well as income tax at their marginal rate on any withdrawals they make.
State Pension and Tax
How much state pension you receive is based on your employment history, and how many National Insurance contribution years you’ve amassed. You usually need 35 qualifying years of contributions in order to be eligible for the full new State Pension, for example.
Another important tax-reminder is that depending on how much State Pension you receive, it can push you into a higher tax bracket.
If your State Pension is £10,000 per year and you receive an additional £20,000 from other pensions, your total income will be £30,000. The first £12,570 will be tax free (this is your personal tax allowance in the 2024/25 tax year). You’ll pay 20% tax on the remaining amount after your personal allowance has been taken.
If you do have to pay tax on your State Pension, this is usually taken through any personal or workplace pensions that you have.
Tax of different Pension schemes
Defined Benefit schemes: If you have a final salary pension, you’ll receive an income for life, which is taxed as earnings. You may be entitled to take a lump-sum withdrawal, but it’s best to check with your provider.
Defined contribution schemes: After reaching the eligible age for taking your pension (55, rising to 57 in 2028), you can start accessing your pension. The first 25% of your withdrawals are tax-free. The remainder is taxed at your marginal income tax rate.
How tax is paid on pensions
Usually, your pension provider automatically calculates the amount of tax you need to pay, and takes this from your pension.
If you also owe tax on your State Pension, they’ll take this from your personal or workplace pension through PAYE (Pay As You Earn).
There may be times when your tax code changes.
Normally, the first time a taxable withdrawal is made from a drawdown provider it will go on an emergency tax code. After this, HMRC will give the provider a tax code, and so the correct amount of tax will be paid on subsequent taxable withdrawals. If you have been over charged emergency tax, you’ll be able to claim it back from HMRC. But there are times when you have underpaid and will need to pay HMRC.
How much tax will you pay?
How much tax you pay depends on what you decide to do with your pension pot.
Here are some of the options available to you in retirement, and their tax implications.
Pension Drawdown: The first 25% of your pot is tax free. The remainder of your pot is taxed as income at your marginal tax rate when you take it.
Pension Annuity: The first 25% of your pot can be taken as tax free cash before you buy an annuity. Any income you are paid from your annuity is taxed at your marginal rate as you receive it.
Taking your entire pension pot: The first 25% is tax-free. The remaining 75% is taxable at your marginal rate of income tax.
Want to find out more about your pension options?
Your pension is designed for later life. When you save into a pension, the value of your investment could fall as well as rise and you could get back less money than you put in. You usually can’t access your pension until age 55 (rising to 57 from 6 April 2028). Tax rules can change and depend on your personal circumstances.
With a Virgin Money Pension you can take your pension savings as one lump sum, with 25% of it tax free. To access your pension another way you'll need to transfer your pension to another provider. We won't charge you to do that.
This article can give you helpful tips, but it isn’t financial, or tax advice. If you’re not sure if something is right for you, you should speak to an Independent Financial Advisor.