How Are Pensions Taxed
As a general rule, when you decide to start withdrawing your pension savings the money is treated in the same way as income from employment and is taxed like any other earned income you receive. However, you have some options on how best to withdraw money to make sure you dont pay any more tax than you need to. The amount of tax you pay will depend on your individual circumstances, and may be subject to change in the future.
Making decisions about how to finance your retirement is important, so its worth shopping around and using available guidance and advice before choosing how to access your pension savings. You can do this through Pension Wise, a free service from MoneyHelper, or Unbiased.
How You Make A Withdrawal
There are several ways you can take money out of your pension, depending on what you need and what youre planning to do in retirement:
Want to know more about these options?
Where Should You Keep Your Pension Tax Free Lump Sum
Bank and building society interest rates for cash savings are currently very low, and have been for some time.
Placing your tax free cash lump sum in a savings account, or cash ISA, can provide security and stability, but also means the value is very likely to become eroded by inflation.
Also think carefully about keeping all of your cash in one place the Financial Services Compensation scheme limit to protect cash deposits if a bank fails is currently £85,000, or £170,000 for joint accounts, per bank, per account.
You may be able to take advantage of cash services that seek out a range of accounts to obtain the best rate for your money. Your St. Jamess Place Partner can help provide you with more information on this.
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Do I Pay Tax On My State Pension
State pension income is taxable, but whether or not you have to pay tax will depend on your total annual income.
Your annual allowance is £12,570 and the maximum new state pension you can receive is £9,627.80. So if your only income is from the state pension, you wont pay any income tax. However, if you have income from other sources that push your income over the annual allowance, you will pay income tax on everything above that figure.
Heres an example. Adam receives the full new state pension, and also has an annuity that pays him £8,000 a year. His total income for the year is £17,627.80. After his annual allowance of £12,570 this leaves £5,057.80 to be taxed at 20 per cent which is £1,011.56. Adams net income after tax is therefore £16,616.24.
State pension income
How Much Can I Earn Before Paying Tax On My Pension
The standard personal income allowance in the UK is £12,570 you can earn this amount before having to pay tax. Income from a pension is classed as personal income, so only withdrawing up to your personal allowance in a tax year, means you wont be liable to pay income tax. Income from a pension is classed as personal income, so only withdrawing up to your personal allowance in a tax year, means you wont be liable to pay income tax.
Its worth considering that earnings from property, interest on savings over your savings allowance, or money taken from a pension pot are all classed as personal income and therefore will be subject to income tax based on the rates below.
This does not include Scotland where the tax bands are slightly different.
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Your Health And Life Expectancy Are Key
Lets continue with the example above. If you take the lump sum, the longer you live beyond 20 years, the higher your annual return will need to be to match the lifetime income payments. Conversely, the shorter your life, the more valuable the lump sum. Take an honest look at your health and family history of longevity before you make your decision.
Taking A Pcls From Your Defined Contribution Pension
If you have a defined contribution pension, you can normally take up to 25% of the plan value as a tax-free lump sum known as a PCLS.
You have the option to take all of your PCLS at once, or in stages.
Each time you access an element of your pension fund , you can receive 25% of the crystallised amount as a PCLS, with the remaining 75% used to provide you with an income through either a one-off taxable lump sum, income drawdown or a lifetime annuity.
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Can I Take A Tax
If you have more than one pension scheme you can usually take a cash lump sum from each one, with up to 25% of each amount tax free. Another option would be to combine your pension pots into one, making them more manageable for tax purposes.
Note: According to HMRC guidelines, if this lump sum is paid from more than one pension fund, you must: have your savings in each scheme valued by the provider on the same day, no more than 3 months before you get the first payment.
Equity release can be used as a tax-free method of extracting value from your home to fund retirement. Try out our equity release calculator to find out how much you can release.
Excess Transfer Of An Rpp Lump Sum Payment
If the amount you transfer is more than the limit, you have to include the excess transfer in your income. Your T4A slip shows the excess transfer as pension income in box 018, which you report on line 13000 of your income tax and benefit return.
If you made the excess transfer to your RRSP for 2021, we consider you to have contributed it to the RRSP in the year in which you transferred it. Even if the excess transfer is made to your RRIF, we still consider you to have contributed it to your RRSP. In both cases, the carrier will give you an RRSP receipt for this contribution.
You can deduct these RRSP contributions on line 20800 of your income tax and benefit return, up to your RRSP deduction limit for the year in which you made the transfer. If you cannot deduct the contributions because they are more than your RRSP deduction limit for the year, you can leave them in your RRSP or your RRIF and deduct them for future years up to your RRSP deduction limit for those years.
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What Are Annuities And How Are They Affected By Pension Flexibility
An annuity is a way of taking a regular income. You hand over your pension savings to an insurance company and in return they promise to pay you a guaranteed income stream.
You can buy different varieties of annuity to suit your personal or family circumstances, for example, the annuity:
- might be for a short period or paid for life
- could be paid during just your lifetime, or could continue to be paid to your spouse or partner after you die
- might die with you, or it could have a guaranteed part that is paid to your beneficiary or beneficiaries after you die. A beneficiary can be anyone you nominate. It does not need to be a family member.
Different types of annuity are explained by Moneyhelper.
The choices you make about what you want from your annuity affect how much is paid. Deciding what to do with your pension pot requires careful thought and you should consider taking financial advice. You might also need to shop around with different providers to get the best value for money .
Pension flexibility and annuities
Annuities still exist alongside pension flexibility. This means that they are an option for you when deciding what to do with your pension savings. For example, you could buy an annuity with part of your pension and take another part of it under the flexible pensions rules. As above, you should try to obtain financial advice if you can. Once you have bought an annuity, if it is for life there is no more flexibility with that part of your pension savings.
How Much Tax Will I Pay On A Lump Sum
With UFPLS, you can take a series of ad hoc withdrawals from your pension fund or funds as and when you need to access the money.
For each withdrawal, the first 25% is tax-free and the remaining 75% taxed as income.
Once you cash in your pension pot, you can take up to 25% tax-free up front and the rest is taxable, see our example, above.
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If You’re Under Pension Credit Age
Only the money you actually take out of your pension is counted as income or capital, not the full amount that you’re entitled to take. The rules are the same otherwise. This means:
- money you take out of your pension will be considered as income or capital when working out your eligibility for benefits – the more you take the more it will affect your entitlement
- if you already get means tested benefits they could be reduced or stopped if you take a lump sum from your pension pot
- if you already get benefits, any money you take out and spend quickly could mean your entitlement gets reassessed
- if the benefit decision maker decides a your motivation for spending the money was to make sure it didnt affect your means tested benefits, you could be seen to still have the money and have your benefits reduced or lose benefits
Can I Take Pension Lump Sum At 55
Changes to the pension rules in 2015 mean that you now have much more choice about accessing your pension at 55. For example, if you have a defined contribution pension, you can access it from 55.
At 55, you can:
- Keep your pension invested and continue to pay into it, and receive tax relief until you are 75
- Access 25% of your pension pot as tax-free cash and leave the rest invested
- Take your entire pension pot as a cash lump sum
- Take just part of your pension pot as a cash lump sum
- Use some or all of your pension pot to buy an annuity to provide a lifetimes secure income
- Use a combination of the above
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Can I Take My State Pension As A Lump Sum
Yes, partially. But it depends on when you qualified for the state pension and whether or not you have chosen to delay when you collect it.
You can opt to defer your state pension – that is, collect after your state pension age. Until the state pension was reformed in 2016, you had two options:
- Defer and boost your weekly pay when you finally collect it, or
- Take the amount you’d deferred as a lump sum.
If you decide to take your deferred pension as a lump sum, you have to put off taking state pension for at least 12 consecutive months.
You earn 2% above the base rate a year. We’ve explained how this works in our guide to deferring the state pension.
The lump sum option is only available to people who reached state pension age before 6 April 2016. Anyone who qualifies for the state pension after that date can only take extra weekly pension.
How Long Does It Take To Get My Pension Lump Sum
Pensions are not like bank accounts it can take a bit longer for pension trustees to process requests for lump-sum amounts. Its not unusual for it to take 2 weeks or more for your pension company to get your money paid out to you.
If its the first time youre requesting money from your pension, it could take even longer. Pension trustees arent known for their lightning-fast customer service, so plan and leave plenty of time until you need the money.
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Use Your Pension Pot To Generate An Income
When youre ready to take an income, there are a few options for using your pension pot:
- A guaranteed income.A pension annuity provides a guaranteed, regular income for life, and is paid for by transferring money from your existing pension pot. The money is taxed as earned income, like a salary. You can also choose to receive a guaranteed income for a fixed term with the option of a maturity lump sum at the end of the term.
- Opt for a flexible income. With income drawdown you leave your pension pot invested and withdraw money when you need it. You can vary how much income you take, which means you can manage the tax you pay. Like an annuity, the money you withdraw is taxed as earned income. Remember, if your pension pot is left invested the value can go down as well as up. It isnt guaranteed, so you may get back less than you put in.
If you want to make contributions into your pension plan after youve started taking an income, youll be restricted to paying in a maximum of £4,000 each year thereafter. This is referred to as the Money Purchase Annual Allowance . You cannot carry forward any unused MPAA from the previous tax year.
TIP: If youre tempted by the security of an annuity, but also attracted by the flexibility of income drawdown, you can mix and match and split your money between both.
You can find out how much income you might receive from your pension savings with our handy calculator
What Can I Take Away
People who have deferred under the old rules may now be claiming sums in the tens of thousands of pounds. Misunderstanding the tax rules on taking a lump sum can cost them dearly.
The problem of getting the tax position right when claiming deferred state pension lump sums is one that will eventually be retired to the history books. This is because those entitled to the new state pension, that is those reaching state pension age from 6 April 2016 onwards, no longer have the option to defer in favour of a lump sum they may only take a higher regular state pension income when they cease to defer.
But for now, the complexity of the quirky manner in which state pension lump sums are taxed remains for those who deferred claiming the old state pension. This, as the Low Incomes Tax Reform Group has seen from its post bag, has been causing a great deal of angst for affected pensioners.
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Emergency Tax And Lump Sum Withdrawals
- Unless a pension provider holds an up-to-date tax code, lump sum withdrawals from a pension plan will be subject to income tax under the emergency rate basis.
- This will result in an overpayment of tax for the majority individuals making their first withdrawal from their pension.
- The overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose.
- The taxation bands are different in Scotland to the rest of the UK.
Pension Schemes Newsletter 68 confirmed that unless a pension provider holds an up-to-date tax code, most lump sum withdrawals from a pension plan will be subject to income tax under the emergency rate basis. Triviality payments and winding up lump sums are taxed at basic rate.
- This will result in an overpayment of tax for the majority of individuals making their first withdrawal from their pension.
- The overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose.
Can I Take A Pension Lump Sum From Multiple Pension Pots
Yes you can. Each pension scheme you have should allow you to take a tax-free lump sum, so you could take out 25% from each of them once you’ve reached the age of 55.
However, you can only take ad-hoc lump sums, or uncrystallised fund pension lump sums, from a defined contribution pension.
With a final salary pension, you’ll only get your tax-free lump sum. The remainder will be paid to you as a monthly income.
Is the pension tax-free lump sum under threat, or will it be changed?
There is always some anxiety about whether the tax-free lump sum will be reduced or taken away from pensioners – with the fear that the government will want to recoup some of the money lost by allowing people to withdraw their cash tax-free.
This usually reaches fever pitch around the time of the Budget, when people are speculating on how the government plans to raise money – and that it is plotting a ‘raid on pensions’.
The current government has expressed no plans to reduce the pension tax-free lump sum, or change it. We do not know what future governments may do – but for now, you’ll still be able to withdraw your money this way.
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