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 (although changes are due to be introduced with effect from 6 April 2029). You can read more in your Plan booklet.
When you retire
At retirement you can generally take up to 25% of your pension pot as a tax-free lump sum (no income or capital gains tax).
However, the amount of tax-free cash that can be taken from all pension arrangements is typically limited to the Lump Sum Allowance (currently £268,275). This equates to 25% of the old Lifetime Allowance (LTA). Some exceptions apply, for example, if you have Lifetime Allowance protection.
Historically, funds drawn from your pension in excess of the LTA were subject to an LTA charge of 55% whereas, the lump sum allowance now means they are treated as income so taxed at your marginal rate of income tax).
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 tax allowances which apply to pension savings are the Annual Allowance, the Lump Sum Allowance, the Lump sum and death benefit allowance and the Money Purchase Annual Allowance.
If you exceed any of these allowances then you may need to pay additional tax charges. Remember these allowances are set by the Government and subject to change. If you’re not sure on whether any of these allowances apply to you, we recommend you discuss this with an FCA registered financial adviser.
Lump Sum Allowance and Death Benefit Allowance
Information about the Lump Sum Allowance is set out in the link above. If you take a lump sum that goes above your LSA, you’ll need to pay income tax, at your marginal rate on the extra amount.
There is also a maximum tax-free amount called the lump sum and death benefit allowance (LSDBA) which applies in certain circumstances and includes any tax-free lump sums payable at retirement or on serious ill-health and certain lump sum death benefits payable to your beneficiaries. This is currently £1,073,100. For further information about these lump sum allowances, visit the Government website.
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.
You can check if your contributions are above the money purchase allowance by using this calculator provided by HMRC.
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. | DrawdownWith effect from 6 April 2027, any remaining savings in your fund may be subject to Inheritance Tax. | 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. |