A guide to tax and your pension

If you’re approaching retirement or over the age of 55 (rising to 57 from 2028), you'll need to know how tax works on your pension. From a defined contribution (DC) to state pensions, we've listed the essential facts you'll need to know. 

It’s important to remember that any money you take from your pension is classed as taxable income, regardless of how you access your funds.

But pensions do differ from other investment vehicles, like savings and investments, in that up to 25% of your pension fund is payable tax-free. How this is applied to your withdrawals will ultimately depend on whether your pot is crystallised or uncrystallised.

So, before we get into the nuances of how your pension is taxed, let’s look at these terms in more detail.

You’ll have a crystallised pension if you decide to either take your entire 25% tax-free benefit in one lump sum, purchase an annuity, or opt for an income drawdown.

If you opt for this type of withdrawal, you’ll typically withdraw up to 25% of your pot tax-free in one go. This tax free cash amount is limited to £268,275. This is known as the pension commencement lump sum and leaves the remainder of your pot liable for income tax at the point of withdrawal. 

To get an overview of the income tax brackets click here.  

Before you set up an annuity, it sometimes makes sense to make use of the pension commencement lump sum.

This is because the 25% tax-free amount is taken before the annuity is set up so all income is directly liable for income tax.

Evaluating if this is right for you will depend on several factors, such as the size of your pension pot, your quoted annuities, and how much you can expect to earn from the tax-free percentage of your pension if it’s reinvested.

All these variables can be discussed with your independent financial adviser.

An uncrystallised pension is when you haven’t set aside money for income drawdown or an annuity. You can access your cash direct from your pension pot and any such payments are known as Uncrystallised Funds Pensions Lump Sums (UFPLS).

This differs to a crystalised pension in how your withdrawals are taxed. Under a UFPLS, 25% of each withdrawal is tax-free while the rest is liable for income tax. This is what differentiates a UFPLS from an income withdrawal.

With an income withdrawal you’ll typically take your entire 25% tax-free portion out in one go, with the remaining drawdown subject to income tax. The tax free amount is capped at £268,275.

If you’re going to opt for a UFPLS, make sure not to withdraw too much of your pension in one go because it can push you into a higher income tax bracket.

To illustrate, consider this example. Jack has £100,000 in his pension which he wishes to release in one lump sum. Of this withdrawal, £25,000 isn’t taxed which leaves the remainder liable for income tax after accounting for his personal allowance.

This means he’ll face a 40% tax charge on £24,729, the higher rate tax for income above £50,271.

Now, if he decided to withdraw this in two instalments of £50,000 over two tax years he’d negate this higher rate tax charge entirely.

The most you can contribute towards your pension while earning tax-relief is the higher of your annual income or £60,000 per year. This is known as your annual allowance, and it remains in place unless you intend to make flexible withdrawals from your pension.

At this point you’ll trigger your Money Purchase Annual Allowance (MPAA), which reduces the amount you can save into your pension tax-free to £10,000 per year. This rule was introduced by the Government to stop people from recycling their pension and effectively earning more tax-relief on their contributions.

Now, it is important to note that the MPAA is only triggered if you opt for flexible withdrawal of your funds. This means if you set up a drawdown arrangement and take a pension commencement lump sum but no further income, purchase an annuity where the income is guaranteed, or take a small pots lump sum the MPAA won’t apply.

If you opt for a UFPLS or take a regular income from a drawdown arrangement, then it does apply.