What is Pension Tax?

Pension tax is the income tax deducted from pension income and pension lump sums.

Income from both state and private pensions is classed by HMRC as taxable and added to any other income you may have to make up your total taxable income.

The income tax deducted from pension income is calculated in the same way as earnings from employment under PAYE.

Understanding pension tax is important for your retirement plans both in the short and longer terms because it let’s you see how much money you will be left with after tax.

In some cases you can reduce the amount of pension tax you pay and be due a refund of tax paid on pension income from HMRC.

How is pension tax calculated?

Tax on pension income follows the same calculation method as earnings from employment.

Individuals receive a yearly personal allowance which allows for a tax free pension income of up to the personal allowance threshold.

The personal allowance is currently expected to be worth £12,570 up to April 2028 and is set against everything you earn not just income from a pension.

If you receive other forms of income you must add this to your pension income to arrive at your total taxable earnings.

Any income exceeding the personal allowance threshold is subject to tax at rates of 20%, 40%, or 45%, depending on your total overall income.

When do I pay tax on pension income?

You start paying pension tax when your pension income combined with other taxable income adds up to more than your personal allowance.

Other taxable income can include:

• PAYE employment income.
• Self employment income.
• Investment income from property or savings.
• Taxable state benefits.

Your pension provider (state or private) will deduct tax through PAYE before you receive your payment.

The tax code issued by HMRC to your pension provider will tell them how much tax to deduct from your pension payments.

How much is pension tax?

Tax paid on pension income is calculated at the rate you pay income tax.

The current income tax bands and rates for England, Wales & Northern Ireland are:

Basic rate: £12,571 to £50,270 @ 20% tax rate.

Higher rate: £50,271 to £125,140 @ 40% tax rate.

Additional rate: Over £125,140 @ 45% tax rate.

Pension lump sum tax rate:

The rate at which you pay tax on a pension lump sum is the same but you get 25% free from tax up to the lifetime allowance and then the remaining 75% is taxed as per your rate of tax.

Is the state pension taxable?

State pension income and lump sums are subject to tax although whether or not you have to pay any relies on your overall yearly earnings.

If your sole source of income is from the state pension you will not normally have to pay any income tax because the total state pension is usually below the personal tax free allowance.

Tax will be due if your state pension income combined with any other additional income surpasses the personal allowance on the portion of income above the PA threshold.

Do I pay tax on a pension lump sum?

In most cases individuals are allowed to withdraw a lump sum from their pension pot.

The government allows 25% from any qualifying pension lump sum to be taken as tax free income.

You can potentially take a lump sum from multiple pensions pots and your personal allowance isn’t affected by the 25% tax free element.

75% of a pension lump sum is taxable which may mean that your income is pushed into a higher rate of tax in the tax year it is taken.

For this reason it can be more tax efficient to take more than one pension lump sum so you can distribute the funds you receive over multiple tax years which could potentially lower the total tax amount you are required to pay.

For people who took a pension lump sum before April 2023 the pension lump sum tax free threshold is restricted to a maximum limit of 25% of the available lifetime allowance which currently stands at £1,073,100.

There is no lifetime allowance charge for any pension lump sums taken after April 2023.

The pension lump sum rules vary depending on the type of pension you have for example a personal pension, workplace pension, defined benefit pension or defined contribution pension.

If you are considering taking a pension lump sum you should check with your pension provider(s) the specific rules surrounding what you can take as a lump sum and when.

Tax on state pension lump sums

If you choose to delay claiming your state pension continuously for a minimum of 12 months you have the opportunity to receive a one off single payment in the form of a state pension lump sum.

The state pension lump sum choice is only accessible to individuals who reached state pension age prior to 6 April 2016.

Does a pension lump sum have to go on a tax return?

The taxable part of a pension lump sum should be included on your self assessment tax return.

HMRC does not need you to declare the tax free 25% portion on a tax return only the remaining 75% from your lump sum.

Any income tax owed to HMRC or refund of tax already deducted will be calculated as part of the normal tax return process.

Can I reduce pension tax?

In certain situations it’s possible to avoid pay tax on your pension income or make use of the methods available that can reduce the portion of your pension that is subject to tax.

If you are receiving pension income or taking a pension lump sum sometimes you can reduce the amount of pension tax you pay by aiming to keep your overall income under tax brackets that have a higher rate of tax.

One strategy for minimising the amount of tax paid on pension income is to limit withdrawals to only the necessary amount for each tax year.

Pension products like a pension drawdown plan or a pension annuity should be considered as part of your retirement planning.

A pension drawdown enables you to distribute your income withdrawals across the upcoming tax years, with the aim of maximising your tax free income allowance or remaining within a lower tax bracket.

Pension annuities offer individuals the opportunity to convert their pension savings into a reliable lifelong or fixed term income.

Can I get a pension tax refund?

Overpaying income tax typically occurs when a pension’s lump sum withdrawal is subjected to an emergency tax rate.

If this happens you can be due a pension tax refund and can claim it back immediately from HMRC by completing a form P53, P53Z or P55 all of which can be done online or by post.

In theory you should automatically receive a refund of pension tax from HMRC but this wouldn’t normally happen until after the end of the tax year which concludes on 5 April each year.

Higher rate pension tax relief

To incentivise individuals to save for their future, the government offers tax relief on pension contributions for those enrolled in a private pension scheme.

Typically everyone gets 20% tax relief applied automatically but if you pay into a private pension scheme and pay tax at a rate higher than the basic rate you are entitled to claim more.

Higher rate pension tax relief is granted at the highest tax rate applicable to the individual but you have to claim the extra higher rate pension tax relief back from HMRC to receive it.

Do I pay tax on pension contributions?

Pension contributions are normally free from tax and shouldn’t be used to calculate your total taxable income.

If you pay more than 100% of your yearly taxable earnings into a pension scheme or more than £60,000 (which is the pension annual allowance) you can either stop receiving pension tax relief on your contributions or have to pay more tax on the excess contributions.

Can I use pension contributions to reduce the tax I pay?

You have the opportunity to receive tax relief on your private pension contributions allowing you to deduct up to 100% of your annual earnings.

When you contribute to your pension in this way a portion of the money that would have been paid as tax to the government is allocated towards your pension instead.

This can effectively lower your tax liability and contribute to enhancing your savings for the future at the same time.

To make pension contributions to help reduce your taxable income your employer generally has to run a salary sacrifice scheme where they consent to make extra pension contributions on your behalf while simultaneously reducing your salary by a specific amount.