Tax, Allowances and State Pension
When you are deciding how you want to take your pension account, it is important to consider the tax you would pay on the different options, and also the benefits you will receive from the State.
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 amount you save into, or build up, 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.
When you retire
In most cases, you can usually take up to 25% of your pension savings as a tax-free cash lump sum when you retire. The amount payable as tax-free cash may be restricted by the Lump Sum Allowance (LSA) – see below.
Alternatively, if you are moving into a drawdown fund or taking more than one cash lump sum, then you may be able to spread your tax-free cash by taking 25% of each future payment tax-free.
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 have transferred your benefits and 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 Lump Sum Allowance (LSA) 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 review and can change this allowance on an annual basis. For the latest information and Annual Allowance figures, please visit this Government website:
Lump Sum Allowance (LSA)
The most you can usually take as a tax-free lump sum from all pension arrangements of £268,275 – this is known as the lump sum allowance (LSA). If you have lifetime allowance protection, the amount of tax-free cash you can take may be higher.
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, currently £1,073,100, called the lump sum and death benefit allowance, that applies to you and your beneficiaries in certain circumstances. This amount includes any tax-free lump sums payable at retirement and certain lump sum death benefits.
For further information about these lump sum allowances, visit the Government website here.
Remember the lump sum allowances are set by the Government and could 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 (see below).
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. You can find the latest MPAA here - the MPAA for 2024/25 is £10,000.
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 is a small pot lump sum and how is it taxed?
If your Scheme pension savings are less than £10,000 you may be able to take this as a small pot lump sum. This means that you can take your entire Scheme pension savings as cash. Up to 25% of the lump sum would be tax-free, with tax paid on the remainder. Taking a cash lump sum in this way would not trigger the Money Purchase Annual Allowance; you would need to let the Scheme administrators know that you are taking a ‘small pot’ lump sum rather than an Uncrystallised Funds Pension Lump Sum (UFPLS).
If you have pension savings in more than one scheme, and your total savings are worth less than £30,000, you may also be able to take all of your pension savings as a one-off lump sum. Please contact the Scheme’s administrators if you believe this could be the case for you.
So how much tax will I actually pay on my retirement income?
You will pay tax on your retirement income at your marginal tax rate, which will depend on the amount of income you receive from all sources.
If you are currently employed and receiving a salary, taking your pension could potentially mean that you move up to a higher tax band.
In addition, if you decide to take all of your pension savings as a cash lump sum in one go, this could mean that you end up paying more tax, as you may move up to a higher tax band.
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 can receive a tax-free lump sum, or receive a tax-free income – as long as the payments start within two years of your death. The amount payable will be subject to the lump sum and death benefit allowance - see above. | CashAny cash remaining from pension savings you have taken from your pension account 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 dependant 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 pension savings you have taken from your pension account as a cash lump sum will form part of your estate for inheritance purposes. |
State Pension benefits
State Pension Age (SPA)
When you reach your State Pension Age, you may also be entitled to receive a pension from the State called your State Pension.
Your State Pension Age will depend on your gender and your date of birth. You can find out your State Pension Age (SPA) here.
State Pension
For individuals who reach State Pension Age, the full amount of State Pension is set by the Government.
However, this amount will be lower if you haven’t paid full National Insurance contributions (or received full National Insurance credits) for 35 years.
This could be due to periods when you were not working and not claiming benefits, had low earnings, were ‘contracted-out’ of a pension plan, or were living abroad.
The amount payable to you will reduce proportionately depending on how many years’ full contributions you have made. You may be able to make voluntary National Contributions to fill any gaps in your contribution record.
You can find out the State Pension you will be entitled to receive here.
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.
How your State Pension increases in retirement
The new State Pension increases each year in line with the highest of the increase in average earnings, the increase in prices as measured by the Consumer Prices Index, and 2.5%.
Delaying your State Pension
You can’t take your State Pension earlier than your State Pension Age, but you can delay it. If you are due to reach your State Pension Age on or after 6 April 2016, your State Pension will increase by just under 5.8% for each year you defer.
You can find out more about delaying your State Pension on the Government’s State Pension website.
Other State benefits
You may also be entitled to other State benefits in retirement. Please visit MoneyHelper to find out more.