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What you need to know about tax on pensions

A basic knowledge of the tax situation is essential if you draw regular or one-off sums from your pension. 

The bulk of this chapter looks at the tax treatment of withdrawals. It also looks at the tax risk that faces wealthy savers who might exceed the maximum amount you’re allowed to build up within a pension during your lifetime.

We’ve written this page under a number of clear subject headings (numbered 1–6 below): if one or other does not apply to your circumstances, you can skip that section.

The need to consider tax

In theory, the mechanics of taking money out of your pension pot as and when you need it should be simple. The platform you have chosen will allow you to set up regular payments to transfer the dividends or other income earned from your pension account to your bank account.

Or, for one-off withdrawals, perhaps from the regular sale of holdings described in Step 4, you can simply transfer money manually from your pension to your current account on an occasional basis.

But before you make withdrawals you need to set up your pension in a way that takes account of – and makes the most of – the fact that you are entitled to take 25% of that pension pot tax-free. And that’s where things get a little more complicated.

Tax and pensions: the basic relationships

One of the biggest reasons to save into a pension in the first place is the fact that you receive income tax relief on your contributions. In other words, it’s as if the money you pay in is not subject to income tax. Someone who pays 20% basic-rate tax (who would take home £80 for
every £100 earned after income tax) gets the following benefit when he or she saves into a pension: their £80 contribution is bumped up by 25% to become £100.

And someone who pays the 40% higher rate of tax (who would keep £60 for every £100 earned) gets the following benefit: their £60 contribution is bumped up by 67% to £100.

Wind the clock forward a few decades: you are now retired and you want to take money out of your pension. In order to truly benefit from the pension system, you want to try to withdraw your pension at a lower rate of income tax than the rate of tax relief that you received when you contributed the money.

One winning scenario would be:

• You paid into your pension as a higher-rate taxpayer, collecting 40% tax relief.

• You take income out of the pension as a basic-rate taxpayer, paying only 20% tax.

Clearly, it is less satisfactory if you pay the same rate of tax on your pension income in retirement as you received in tax relief on your pension contributions while you were working. In that situation, the tax flows would cancel each other out. You have saved 20% tax when you contributed money to the pension while you were working, but you then pay 20% tax on your income from the pension when you have retired.

In this case, your only benefit would be the 25% lump sum: here you received full tax relief upfront but will pay no tax when you take the lump sum out. That’s why the tax-free lump sum is so important. It needs to be cherished.

Once the tax-free lump sum has been taken, any withdrawals that you make from the remainder of your pension pot are subject to income tax just as if they were wages (although there is no National Insurance to pay on withdrawals from pensions).

Under current rules and allowances, everyone can receive £12,500 income per year and pay no tax on it at all. This is called the personal allowance. The next £37,500 attracts tax at 20%. Above that, income is taxed at 40%.

There is a further additional rate of 45% on income over £150,000 in any one tax year.

Please note these allowances are subject to frequent change. Slightly different rates and bands apply in Scotland.

The following six sections of this page deal with this issue of the tax-free lump sum and the remaining, potentially taxable part of your pension pot.

1. The basics of your 25% tax-free entitlement

Previous governments decided that when people retired they would need a lump sum of cash to set them off in this new stage of life, along with an income that would see them through the rest of their days.

The two important principles here are:

1. The lump sum would be free of tax.

2. The income thereafter would be taxed, just as earned wages are taxed. Therefore, for income above the annual tax-free personal allowance, income tax is payable.

As we’ve covered in earlier chapters, the financial landscape facing retirees today is not quite as straightforward as for earlier generations. But those basic principles remain. One quarter of your pension pot can be taken free of tax. And this is a very valuable perk for everyone.

How you maximise the value of your 25% tax-free portion very much depends on your circumstances. What you want to try to do, as much as possible, is spread your pension withdrawals so that you are not pushed into a higher tax bracket in any one year.

The following examples highlight various possibilities. All figures are for the 2019–20 tax year.

Scenario one: income needed now

Q: I’m 56 and earn £17,000 a year in a part-time job. I plan to keep this job for the next two years, after which my mortgage will be cleared. I have a substantial pension pot of about £350,000. To help me through this period I want to take £15,000 a year from my pension pot, starting now. How much tax will I pay?

A. Putting aside your entitlement to the 25% tax-free lump sum, you’ll pay 20% income tax on all of your £15,000 pension income, so you’ll pay tax of £3,000. That’s because your earned income of £17,000 already takes you above the £12,500 annual personal allowance.

Scenario two: capital needed now

Q: I’m 56 and earn £17,000 a year in a part-time job. I plan to keep this job for the next two years. I have a substantial pension pot of about £350,000. I want to take £80,000 out in a lump sum to help my son buy a house. How much tax will I pay?

A. Putting aside your entitlement to the 25% tax-free lump sum, you’ll pay 20% income tax on £33,000 of your pension withdrawal, and then 40% on £47,000.

Here’s how it adds up: your £17,000 earned income uses up your full £12,500 personal allowance. You can take £33,000 of your £80,000 pension taxed at the basic rate of 20%, because you are allowed income of up to £50,000 while paying the 20% tax rate. Beyond that threshold, you pay the higher rate of tax, so the remaining £47,000 of your pension payment is taxed at the higher rate of 40%.

20% tax on £33,000 = £6,600

40% tax on £47,000 = £18,800

In total, you’ll pay £25,400 tax on your £80,000 pension withdrawal.

If the people in our scenarios made use of their 25% tax-free allowances, however, they could save a great deal of tax.

In scenario one, the person could withdraw £30,000 from their pension tax-free, to get through the next two years. After that, he or she would no longer be working, but nor would there be a mortgage to pay. They could live on a smaller income where a higher proportion of their total income could then be set against their £12,500 personal allowance. They would still have some tax-free cash left to take as well.

In scenario two, the £80,000 should come from the tax-free lump sum. For all £80,000 to be tax-free, the pension pot would have to be £320,000 or more – but the aim would be to obtain as much of the £80,000 as possible from the tax-free portion, even if the pension pot were smaller. This would cut the £25,400 tax bill or even eliminate it.

While simplistic, these examples show that it is important to try to bear your pension in mind when it comes to major life events such as stopping paid work or making major one-off financial transactions.

The tax-free lump sum plays a special part in this: it’s your ticket to large one-off withdrawals from your pension pot.

Married couples have further flexibility because they can each draw on their pension money at different times, with an eye to minimising their overall tax liability. The broad principle is that it is better for each of the couple to draw smaller sums from their pension in one year than for one person to draw one larger sum. This is especially the case where incomes are close to one of the tax thresholds.

For example, if a couple need £24,000 to live on for a single year, it will be more efficient to try to arrange matters so that each withdraws £12,000 from their pension rather than one person withdrawing all £24,000.

Say Mrs Trellis takes the entire income of £24,000 from her pension. Beyond her £12,500 annual allowance, she will pay tax at 20%. So she pays 20% of £11,500, which is £2,300. If Mr and Mrs Trellis can fix things so that each withdraws £12,000, they each pay no tax on just £150. The arrangement would thus save them £2,300 in tax.

2. How to take all the tax-free money out at once, leaving the remaining 75% invested

Let’s say your pension pot is worth £100,000. It’s invested in one of the portfolios outlined in Step 3. But now you want to access some of the money. In the simplest scenario, you want just the £25,000 tax-free element encashed today, and to leave the rest invested.

This is a popular option. In many ways it follows the old pattern before the pension freedoms existed, when retirees would typically take the 25% lump sum and then spend the rest on an annuity, which would pay them an income for life. In this case, tax was payable only on the annuity income.

Now, though, we’re more likely to be considering taking the 25% and then leaving the rest invested to provide a mix of income and growth for years to come. This route is called ‘drawdown’.

For once, here’s a pension term that makes sense: most of your invested pension pot will be left untouched, from which future income and/or lump sums can be drawn down. We outlined our tactics for working out how much you can safely draw down in Step 4.

3. How to take only part of the tax-free money and leave everything else invested – partial drawdown

There may be sound tax reasons not to take all of your 25% tax-free entitlement at once. This is particularly the case where savers have amassed larger pension pots. Say your pension pot is worth £800,000. Let’s recall the scenario above where the saver wanted to give their son £80,000 towards buying a house.

If you were in your late 50s and had a pension pot of £800,000, why encash all £200,000 (the maximum 25% tax-free lump sum) if the need was for only £80,000? Although there would be no income tax to pay on the £200,000 withdrawal, the money would then be outside the pension and lose the associated tax protection. Any future income or growth it generated would become liable to tax.

To follow this scenario through, say you took £200,000 and, after giving your son £80,000, you had £120,000 remaining. As you have no immediate need for this money, you invest it alongside your pension money in exactly the same mix of funds. But the difference would be that the income and growth generated in future from this £120,000 would have to be declared to the taxman, as it is no longer held in a tax-protected pension account.

Not only would you end up paying more tax, but you would have the considerable headache of having to calculate the tax liability.

The solution is to take ‘partial’ or ‘phased’ drawdown.

You start with £800,000 and, in this case, you move £320,000 into drawdown, which allows you to release £80,000 (the 25% tax-free lump sum from the £320,000) to give to your son. Your pension provider keeps a record of the fact that there is now £240,000 of your pension (£320,000 less £80,000) which no longer carries a tax-free cash entitlement. This money can remain invested, however, just as before.

The other, untouched element of your pension pot, of £480,000, still has the benefit of the 25% tax-free lump sum attached to it; this can be withdrawn in future.

Those likely to benefit from partial drawdown

In theory you can enter into multiple, repeated processes like the one described above. The disadvantage is that it can create complexity in managing your overall pot of pension money.

Partial or phased drawdown is likely to be worth considering if you’re younger, if you have a large pension pot and if you’re still earning an income, or likely to earn again in future.

The latter point is important. As you will see below, there are specific rules that apply to how much you can pay into a pension once you have taken some money out of it. Broadly speaking, if all you have taken out is your tax-free lump sum, you can continue to pay into your pension under the normal rules.

But if you have drawn income from the main, taxed portion of your pension, your ability to contribute in future is much reduced. If you are still earning and able to put some money into your pension, you need to be careful not to limit that ability by any actions you take early on in the years beyond age 55. 

The rules relating to contributions in these circumstances are explained more fully in point 5 below.

4. How to take successive withdrawals where 25% is always tax-free

What if you wish to make successive withdrawals where 25% is always tax-free and 75% is taxed?

This process is known as ‘UFPLS’ – see the jargon buster below – and has as its main benefit an element of simplicity.

Here, every time you make a withdrawal from your pension pot, 25% of that withdrawal is tax-free and 75% is taxed. But, as you will have gathered from reading the above points, this is not necessarily very helpful, because it does not allow for much planning. Think back to our case study who wanted to take £80,000 tax-free out of their pension pot to help a child buy a home.

In some cases, UFPLS may suit those with smaller pension pots who wish to encash the entire pot all at once.

Such a scenario isn’t likely to arise among readers of this book, who are expecting to continue investing most or all of their pension for some years into the future. The major downside is that as 75% of every withdrawal is potentially taxable, you are limiting yourself to smaller withdrawals only – or exposing yourself to the risk of paying unnecessary tax.

The second disadvantage – see below – is that it much reduces your ability to contribute further into a pension in future.

Jargon buster: What on earth does UFPLS mean?

While drawdown is a logical term that describes what’s happening to your pension money, the horrible term UFPLS is meaningless. It stands for ‘uncrystallised funds pension lump sum’. It describes a process where every slice of pension withdrawn is treated as a mini-pension, with 25% of the withdrawal being tax-free and 75% liable to tax.

5. What happens if you take money from your pension – but then want to put more in again at a later date

While technically we can all now get hold of our pension savings from age 55, many of us won’t want to stop working at such an early age – and many won’t be able to afford to. What’s likely to happen in most people’s lives is that their pension, earnings and other savings all play a combined part for some years in meeting a range of financial objectives. Tax is a major consideration here.

After your home, your pension is likely to be your biggest asset. So it is natural that you might wish to turn to it to provide a lump sum while you remain in your 50s or 60s.

Earlier in this chapter we raised the scenario of a well-off pension saver wishing to access their pension pot to give a child £80,000 towards buying a house. But you might want to use money inside a pension to pay for a child’s university education. Or to clear your own mortgage. Having used the pension to provide this lump sum, you may still fully intend to continue working for a decade or more, during which time you will want to replenish the pension pot and take advantage of the generous tax relief available in doing so. The rules around this are changing.

Once you have accessed pension money (over and above the 25% tax-free element), you are restricted to contributing a total of £4,000 into a pension each tax year. By contrast, if all you have done is take tax-free money under your 25% lump sum entitlement, you are able to contribute up to the usual allowance, which for almost everyone is £40,000 per year, including
your company’s contributions.

If you are taking cash from your pension while still planning to continue working and contributing further to your pension in the years ahead, you should consider using drawdown and withdrawing only your tax-free entitlement.

Let’s look at an example to illustrate this.

Gary is 62 and has previously used partial drawdown to encash £30,000 of his £300,000 pension pot. Last year, he took 25% of the £30,000 (£7,500) as a tax-free lump sum to pay for refurbishments to his kitchen, and left the remainder (£22,500) in his pension.

He then decided to go back to work as a business consultant for two years when aged 63, and earns £100,000 a year. Out of that money, he is able to continue to make contributions to his pension, up to a maximum of £40,000 per year, because he has not yet taken any of the taxable portion of his pension.

Conversely, if Gary had followed the UFPLS process, and withdrawn the full £30,000, paying no tax on 25% of it and subjecting 75% of it to tax, he would have started taking taxable benefits from his pension pot and he would now be limited to paying a maximum of £4,000 a year of new money into his pension.

Jargon buster: What on earth is the MPAA?

MPAA stands for ‘money purchase annual allowance’, another tongue-twisting, brain-curdling invention of the pensions world. This describes the reduced annual contribution limit to pensions that applies once someone has dipped into the taxable part of their pension.

6. When I take money from my pension, how is the tax actually paid?

Very often you arrive at an understanding of how tax works in theory. Then, in practice, when the deductions are being made or HMRC is asking for certain pieces of information, it all becomes incomprehensible again.

It’s worth knowing what to expect when you make withdrawals. Firstly, if all you’re taking is tax-free money, you’ll pay nothing in tax. That part is rather obvious!

When you start to make withdrawals outside your 25% tax-free entitlement, however, you will be subject to tax as if the money was earned income. In this case, your pension provider will perform similar functions to an employer under the pay-as-you-earn (PAYE) system. It will obtain a tax code from HMRC, and it will apply this to the money you withdraw.

The first time this happens your provider might need to apply an emergency tax code, which may mean too little or too much tax is deducted. You will need to look carefully at your statement and check with HMRC where you suspect errors.

If your first taxable withdrawal is made shortly after you leave employment, or while you’re still working, send your pension provider details of your tax code from your P45 or P60.

You can check how much tax you’re paying using the ‘Check your income tax for the current year’ service available at’ll need to be registered for online access to HMRC.

Once a pension payment has been made to you, your provider should be sent an updated code by HMRC. Payments thereafter should be taxed more accurately. Because the pension freedoms are relatively new, it is not yet clear how well HMRC – already battling to apply a highly complex tax regime – is succeeding in accurately taxing withdrawals.

Those who make regular withdrawals from their pension pots are less likely to suffer errors – or, at least, they should be easier to correct once spotted. If you’re making ad hoc withdrawals, however, it is a good idea to keep a close eye on how much tax you are paying, on those withdrawals individually and for that year in total.

The lifetime allowance

This section is for people with large or multiple pensions. If your pension pot is approaching £1m, or likely to reach that value in future, you should read this. You should also read it if you have a generous final salary pension income from one or more jobs. Otherwise you can skip this section.

What is the lifetime allowance?

The lifetime allowance is a fixed sum above which the value of all your pension savings is not allowed to rise during the course of your life. First set at £1.8m, it has fallen steadily. In April 2014 it fell to £1.25m and in April 2016 it was cut again to £1m. It then rose slightly, in line with inflation, to £1.055m for the tax year 2019–20.

How do I work out if my pensions are at risk of exceeding the lifetime limit?

It’s not that easy, in practice. If you have no final-salary entitlements and have amalgamated all your other pensions, as outlined in Step 1, you should have a good idea of the value of your total pension pot. If it is with one provider, it equates to your total balance.

But many people for whom the lifetime allowance is a risk will also have other final-salary type pensions, whose value (for the purpose of the lifetime allowance) is calculated in a different way. Broadly speaking, you multiply the initial annual income to which you are entitled under such schemes by 20 in order to obtain a value of the pension for the purposes of the lifetime allowance.

Here’s a simple example.

You have a pension pot, from which you have yet to take any benefits, worth £620,000. You also have an entitlement to two different final salary pensions, which will pay you starting pensions of £7,000 and £3,200 per year respectively.

You add £620,000 to £140,000 (20 x £7,000) and £64,000 (20 x £3,200). Any additional tax-free lump sums to which you are entitled from your final salary pensions must be added on top. We will assume none applies here. Your state pension entitlement isn’t included. That makes a total of £824,000.

In this case, depending on your age and other circumstances, you may have some cause to worry that in due course your savings will break through the limit – even if you do not contribute further money to your pension. Strong investment growth on its own could push you above the allowance. You may need to take action.

How does the taxman check whether I’ve exceeded the lifetime limit?

There are several key triggers when your pension provider will apply a lifetime allowance check. The main ones are:

• If you use some or all of your pension money to buy an annuity before age 75.

• If you move your pension pot into a drawdown arrangement before age 75.

• If you take a lump sum out of your pension pot without being in a drawdown arrangement  while under age 75.

• If you die before age 75 and your spouse or other beneficiary does any of the above.

• When you reach the age of 75.

What penalties apply if I exceed the allowance?

Higher rates of tax apply. Your provider will apply a high 55% rate of tax to the excess when it is drawn from the pension as a one-off sum, or 25% tax if you take it as income.

In an ideal world, a pension saver would detect the risk and avoid exceeding the allowance. The worst-case scenario is where more contributions are being made to a large pension and these contributions are themselves responsible for pushing it above the threshold.

Less disastrous is the scenario in which successful investment returns drive the value of the pot above the limit: in this case you are not losing money, you are simply keeping less of the gain made on it.

In any case, you may be able to successfully avoid the tax penalties by applying for ‘protection’ allowed for in the law – see below.

What action can I take?

The most obvious action to avoid exceeding the allowance is to stop contributing to your pension when the risk emerges. If that’s not enough, you could also withdraw money to ensure you remain below the limit.

You may pay tax when you do this, but not as much as you would if you allowed the pot to breach the lifetime allowance.

For those in final salary pension arrangements where benefits are still being accrued, you could consider retiring early (this is typically likely to apply only to senior civil servants, NHS employees and a handful of other groups).

You can also boost your lifetime allowance by taking out ‘protection’. There are several types, but these are the two you’re most likely to use:

1. ‘Fixed protection 2016’

This locks your lifetime allowance at £1.25m (its level before April 2016). But if you obtain this protection you can no longer put any money into any pension arrangement. Nor can your employer. Your invested pensions can however continue to grow up to that higher limit.

2. ‘Individual protection 2016’

This locks your lifetime allowance to the lower of the two following figures: the total value of your pension(s) at 5 April 2016 or £1.25m. In other words, this works only for those whose pensions were above the £1.25m limit in April 2016.

You are technically permitted to continue to contribute to your pension, but in practice your opportunities to do so will be very limited.

Both of the above get-outs are useful for well-off savers, and mean that in many cases tax penalties can be avoided. There is no set deadline by when these protections need to be applied for. But the more time that passes, the less useful they become.

If you discover that you have exceeded the limit already and have been making further contributions since April 2016, you are likely to need professional help. See our page on financial advice for more on where to find such help and how much it might cost.

Finally, a note on buy-to-let

An estimated two million people own properties in addition to their home and let them out. Many are doubtless counting on the rental income to help them through retirement. Some will have built portfolios of buy-to-let properties specifically to generate retirement income.

The scope of this website doesn’t stretch to the pros and cons of buy-to-let. While certain types of pension allow investors to hold commercial property, residential property is not allowed inside a pension. Buy-to-let is not therefore core to the subject of how to manage and invest your pension assets.

But in relation to tax, there are a number of points to consider when looking at the issue of whether money saved up inside a pension should be taken out and used in other investments, notably buy-to-let.

Here is a question savers often ask:

“Wouldn’t it be a good idea to take money out of my pension and invest it in a buy-to-let property?”

The answer, broadly speaking, is no.

Putting aside the risks, costs and practical difficulties inherent in managing a property, and putting aside the comparatively low yields now offered by residential property in many regions, there are some serious tax disadvantages in undertaking this course of action.

With a pension:

• Income generated by the investments inside the pension is tax-free.

• Capital growth of the investments inside the pension is tax-free.

• The pension assets can be passed on at death free of inheritance tax.

With a buy-to-let:

• Rental income is subject to tax along with all your other income. 

• Capital gains on the property are taxed at the highest rates of capital gains tax.

• The buy-to-let properties will form part of your estate and so be liable to inheritance tax.

Earlier parts of this page have raised the question of what you would do with money removed from inside a pension if you did not have an immediate need to spend it or give it away.

The problem is that the pension offers good protection from tax while assets remain within it. Once outside, any returns and growth generated by the money are likely to be taxable. With buy-to-let, which is taxed differently from other investments, this is especially the case.

If you have enough money in your pension pot to be able to withdraw a sum sufficient to buy a property, you are likely to need to think about inheritance tax. Buy-to-let is particularly inefficient from this point of view.

Inheritance tax – and the value of your pension as a way to limit it – is the subject of another of our guides on this website.

‘HMRC can take huge amounts of tax from pension withdrawals’

By Sir Steve Webb, former pensions minister and director of policy at Royal London, the insurer

One of the unexpected (and rather unwelcome) features of the new pension freedoms has been the way HMRC has chosen to administer the deduction of tax from initial pension withdrawals.

Beyond any tax-free lump sum, pension withdrawals are taxed as income in the year in which they are taken. A large withdrawal in one go can see someone drawn into the 40% or 45% tax bracket. This is one of a number of reasons why spreading withdrawals over several years rather than taking them in a lump sum can be a good idea.

For regular taxable income such as wages or regular pension payments, HMRC operates a pay-as-you-earn (PAYE) system which tries to smooth your tax bill over the course of the year. Each month, HMRC looks at how much taxable income you have received so far that year and looks at how much tax-free allowance you are entitled to in that year, and works out your tax bill accordingly.

This is known as a cumulative tax assessment. For most people, it results in paying the correct amount of tax with no end-year adjustment.

But for many people who take taxable cash under the pension freedoms, this is not how the system works. Unless your pension provider already has a PAYE tax code for you, it will deduct tax using an emergency tax code for all but the smallest withdrawals. Under this emergency or non-cumulative system, you are treated as if you were going to make a similar withdrawal every month of the year.

Not surprisingly, this assumption would take most people well into the higher tax brackets, and a big tax bill is the result. In the long run, this problem should be sorted out. You can apply at once to claim back any overpaid tax and if you do not do this HMRC maintains that it will all be sorted out by a reconciliation process at the end of the year.

But if you want the full value of your pension withdrawal now, you are unlikely to be very happy to see a large tax deduction that you then have to claim back.

One possible way round this problem is to make a nominal withdrawal – for example, just £1 – before the one you actually want to make. This process is likely to trigger HMRC to issue a regular tax code to your pension provider and subsequent withdrawals can then be made on the more normal (cumulative) basis.

In my view it is an absurdity knowingly to overtax savers and leave it to them to claim back their overpaid tax. If emergency tax codes are needed, the right thing to do would surely be for HMRC to deduct basic-rate tax at source in all cases. This would get the tax bill right for most people. For high earners any taxable withdrawals could be declared on their tax return and any additional tax due could then be collected.

HMRC should not be allowed to get away with overtaxing people simply because it is more convenient for the taxman.

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