Contrary to popular belief, pension payments are not tax-free money.
Just because you’re not working, doesn’t mean you no longer have to pay tax.
When you pay into your pension, you get all the benefits of tax relief i.e. not paying tax on what you’re contributing to your retirement pot.
But when it’s time to retire and start withdrawing from your pension pot, you may be taxed on it.
Basic principle 1: pension payments are classed as income, just like a salary.
That means that they are treated like a salary for UK tax purposes:
You’ll have a personal allowance (an amount you can earn tax-free)
Then anything above that will be subject to tax
The only difference is that you won’t pay National Insurance on pension payments.
When we think of earnings and tax on our pension, there are two common scenarios.
1) Your pension(s) is your only source of income. You’ve stopped working completely and have no other sources of income.
2) Your pension provides some of your income. But you’re also still getting an income from your job.
Let’s start with the most common scenario - retiring from work completely
If you’ve retired at the age for getting the State Pension, you’ll be eligible to receive your weekly payments. If you get the maximum State Pension, that comes to £10,600 a year.
The State Pension is, in itself, not tax free.
It is paid to you as a ‘gross payment’ i.e. no tax is deducted at the time, but you may need to declare it on your tax return at the end of the tax of year.
However, if you have no other earnings, your State Pension most likely won’t be taxed.
That’s because £10,600 is below the annual personal allowance for income tax, currently £12,570 for 2023/24.
On top of your State Pension, you (hopefully) have a personal pension that you’ve built up over the years from previous jobs and personal contributions.
Basic principle 2: you can take 25% of your personal pension as tax-free income
Over the years, your personal pension builds up to a lump sum value.
Once you reach age 55 (this age will increase in the coming years), you then decide how much, and when, you take that money out. You could leave it untouched for a bit longer or withdraw the entire thing at once and have all the cash in your bank.
The tax implications may be very different depending on your pension withdrawal strategy.
Let’s use an example to demonstrate
Our personal pension has a current value of £100,000. But we only want to take out £10,000 this year.
Of that £10,000, 25% is tax free. So that’s £2500 paid straight into our back pocket, thank you very much.
£7500 is left. This is the bit we are concerned about when it comes to paying any tax.
Now let’s start layering up our pension payments like a stack of pancakes.
Every year, we have a new stack of pancakes.
This year we have the following taxable payments:
Our bottom pancake is our State Pension of £10,000 a year.
Our next pancake is our Personal Pension with a payment of £7500.
We essentially need to consider these two types of pension payments as different jobs.
Imagine you worked two jobs and had two salaries paid to you every year.
We combine both these payments to give a total amount, and then see if any tax is to be paid.
£10,600 + £7500 = £18,100
£12570 of that is tax free, because its within the personal allowance for income tax.
That leaves £5,530 that is subject to income tax which is £1,106
So that’s a take-home total of £16.994 (£12,570 + £5,530 - £1,106)
When we add in the £2500 tax free element of our initial £10,000 personal pension payment, that comes to £19,494.
Now lets looks at scenario 2 – pension payments while you’re still working
Firstly, you’re legally entitled to your State Pension when you reach the State Pension Age. You don’t have to stop working in order to receive payments. And more people are continuing to work in what is now a hybrid form of retirement.
Let’s assume we’ve decided to work part-time and earn £10,000 a year. On top of that, we also start receiving the State Pension. We also have a personal pension pot worth £100,000
Our stack of pancakes looks like this:
Our bottom pancake is our £10,000 annual salary
Our second pancake is our State Pension of £10,600
Our third pancake is our Personal Pension with a payment of £3750 (£5000 minus 25% tax free already taken)
Our total income for the year is £24,350.
When we deduct the personal allowance of £12,570, that leaves us £11,780 subject to tax.
Key points to remember
1) Think of pension payments like earnings. As if you were being paid a salary.
2) You don’t pay National Insurance on pension payments.
3) Your Personal Allowance for income tax is key…it reduces/removes your tax liability on pension payments.
4) 25% of your Personal Pension payments are tax free.
5) All forms of income stack up like pancakes when calculating any tax you will pay on pension payments.
When it comes to earnings and pension payments, they’re really the same thing when it comes to tax. And the more you earn, the higher your tax bill.
