How does tax on pension savings work?
When you are building up savings…
You won’t usually have to pay tax as you save into a pension unless the total amount saved into the HRP over the tax year exceeds the Annual Allowance.
This means that saving into a pension arrangement is usually tax efficient, as you receive tax relief at your highest marginal rate of income tax.
For example, if you are a basic rate tax payer, for every £100 you save into a pension, this only costs you £80.
Plan contributions are usually paid through salary sacrifice, which means they are paid before tax. You can read more in your Plan booklet.
When you retire
Previously, the value of your pension savings would have been tested against the Lifetime Allowance (LTA) when you retired. If your pension savings were greater than the LTA (£1,073,100 in the tax year 2023/24) you would have an additional tax charge. However, on 15 March 2023 the Government announced that it intends to abolish the LTA from 6 April 2024, with no LTA charges from 6 April 2023. For more information about the LTA, please visit the Government website at gov.uk/tax-on-your-private-pension/lifetime-allowance.
Remember, the LTA is set by the Government and is subject to change.
When you’re drawing a retirement income
Once you have taken any tax-free cash at retirement, the remainder of your retirement income will be taxed at your marginal rate of income tax as you receive it.
This works in a similar way to the tax you currently pay on your employment income, except you won’t have to pay any National Insurance Contributions.
If you are spreading your tax-free cash by taking 25% of each payment tax-free, then any amount above this on each payment will be taxed at your marginal rate of income tax.
What are the Allowances?
The three Allowances which apply to pension savings are the Annual Allowance, the Lifetime Allowance and the Money Purchase Annual Allowance.
Annual Allowance
The Annual Allowance (AA) is the maximum value of pension savings you can build up over a tax year without incurring a tax charge. The Government reviews, and can change this allowance on an annual basis. For the latest information and Annual Allowance figures, please visit this Government website
Lifetime Allowance
The LTA was introduced in April 2006 to limit the maximum value of pension savings that individuals can build up over their lifetime (in all arrangements) without an additional tax charge.
On 15 March 2023 the Government announced that it intends to abolish the LTA entirely from 6 April 2024, with the LTA charge being removed from 6 April 2023.
For more information about the Lifetime Allowance, please visit the Government website at https://www.gov.uk/tax-on-your-private-pension/lifetime-allowance.
Remember, the LTA is set by the Government and is subject to change.
Money Purchase Annual Allowance
The Money Purchase Annual Allowance (MPAA) applies once you have accessed your pension savings ‘flexibly’ and taken a taxable income. This includes taking taxable income from a drawdown account, as well as the taxable part of a cash lump sum, known as an Uncrystallised Funds Pension Lump Sum or UFPLS. It doesn’t apply if you buy an annuity or if you take a small pot lump sum.
Once the MPAA is triggered, this restricts the amount of pension savings you (and your employer) can make into a money purchase (defined contribution) pension arrangement each tax year without incurring a tax charge. For the latest information and MPAA figures, please visit this Government website
You will need to make sure that you tell any other defined contribution pension arrangements that you are continuing to save into that you are subject to the MPAA so that they can assess your contributions against this lower level.
To assist you with this notification, your pension provider should send you a ‘flexible-access statement’ within 31 days of you first taking a taxable withdrawal. You will then need to let your other pension providers know within 13 weeks of receiving your ‘flexible-access statement’, otherwise you may be subject to a fine.
Therefore, if you are planning to continue working and/or saving into a pension arrangement after taking any of your pension savings, you should take the MPAA into account when deciding which option to take.
What tax will my dependants pay on my death?
The amount of tax your dependants pay depends on how you take your pension savings and how old you are when you pass away.
| If you die… | Annuity | Drawdown | Cash |
|---|---|---|---|
| If you die…Before age 75 | AnnuityIf you have bought a joint annuity, which includes a regular income for your dependant following your death, they will receive their income tax free for the rest of their life. | DrawdownYour dependants may receive a tax-free lump sum or receive a tax-free income – if the payments start within two years of your death. | CashAny cash remaining from your pension savings that you have taken as a cash lump sum will form part of your estate for inheritance purposes. |
| If you die…Age 75 or over | AnnuityIf you have bought a joint annuity, which includes a regular income for your dependants following your death, they will receive their income for the rest of their life and will be taxed at their marginal rate of income tax. | DrawdownYour dependants will pay tax at their marginal rate of income tax, whether the account is paid as a lump sum or a regular income. | CashAny cash remaining from your cash lump sum will form part of your estate for inheritance purposes. |
Tax on your State Pension
Income from your State Pension will be taxed at your marginal rate of income tax, in the same way as other retirement income.