Do I have to pay tax on my pension?

The Pension Freedoms legislation was introduced in April 2015, and since then, people have had a lot more flexibility with how they can withdraw funds from their personal pension funds. As a result, however, it can be increasingly confusing what the tax implications are depending on how you choose to access your pension. When you combine this with receiving the state pension also, it can be even more complicated to understand when you might be taxed, how much, and how.

Whether you decide to continue working or not, once you reach retirement age, you will be able to begin accessing certain pension funds if you have these available. It is important to be aware that there are two different retirement ages, and that both are changing over the next few years, as well as determine which funds you’ll be able to draw from.

Since 2011, there is no longer a default retirement age. This means that employers cannot force people to retire at 65. You are able to continue working as much or as little as you would like to (or need), as well as receive any pension income you may be entitled to.

What is the retirement age?

Generally speaking, you can retire at any age you wish to (or are able to) and there is no mandatory age where you must stop working. Usually however, when people use the term ‘retirement age’ they are referring to the age at which you can start accessing your pension. Personal pensions such as any private pension funds you may have paid into, and also workplace pensions, will set an age at which you will be allowed to start using the money that has been saved. Since 2010, the ‘normal minimum pension age’ (NMPA) rose to age 55 from age 50. In 2028, the NMPA is due to rise to age 57.

The state pension age can sometimes be interchangeably referred to as retirement age, however this is different to the NMPA. The state pension age is the age at which you are able to start accessing the state pension, which you’ll be eligible to receive depending on how long you have paid National Insurance (NI) contributions for. Currently the state pension age is 66 however it is due to rise to age 67 between 2026 and 2028. It is further planned to rise to age 68 between 2037 and 2039, but this has not been confirmed yet.

What is the difference between a state pension and a personal pension?

Aside from one of the key differences between a state pension and personal pension being age, as explained above, they are also different due to how they are funded. The state pension is provided to you by the government, who are able to do so by collecting National Insurance from all those who are working and earn above a minimum threshold. Effectively, this means that every working generation pays for the generation above them.

The state pension is a fixed amount you can receive each week. How much you’re entitled to receive is dependent upon the number of years you have contributed NI. Currently, you need to have 35 qualifying years to be eligible to receive the full state pension – which is £203.85 per week for the tax year 2023/24. You will receive a proportion of this amount if you have between 10 to 35 qualifying years. You can check if you have any gaps in your NI contributions and also make voluntary contributions to top it up. Each year, the state pension amount is promised to increase by whichever is highest out of:

• Average national earnings
• Prices measured by the Consumer Prices Index
• 5%

This is known as the pension triple lock and was introduced in 2011. However, since then, there have been plans to review and amend this policy. Any changes are likely to be confirmed or come into place from 2024.

Unlike the state pension, a personal pension is one which you can choose to set up or not. If you are enrolled onto a workplace pension scheme, this is also considered to be a form of personal pension. You can choose how much you put in but there is a limit if you want to benefit from tax-free savings which are:

• 100% of your annual earnings up until a maximum of £60,000 per year
• Note that as of April 2023, the £1,073,100 as a lifetime allowance has been abolished

Your personal pension will be largely funded by yourself; however, the government want to encourage more people to save and plan for the future and so have incentivised personal pensions by offering those who do save tax relief. Every time you pay into a personal pension fund, the government provides tax relief which means you need to put in less yourself to receive more overall. The amount of tax relief you are eligible to receive is dependent upon your personal income tax band. As an example, those who are on the basic rate of 20% will only need to pay in £80 for a total of £100 to be paid into the pension scheme.

If you are enrolled onto a workplace pension scheme, your pension fund will be part funded by your employer. Since 2012, the government made it mandatory for employers to automatically enrol employees onto a workplace pension scheme, but you do always have the choice to opt-out. To maintain a workplace pension fund, you need to pay in at least 5% of your salary and your employer is required to contribute at least 3% of your salary. As such, in both instances, by investing in a personal pension yourself, you’ll effectively be receiving free money from others as well.

Once you have reached NMPA, you have the choice as to how much you want to take from your pension fund. Depending on how you choose to withdraw funds from your pension, there will be different tax implications.

Do I have to pay tax on my state pension?

Receiving any amount of state pension is considered to be income and therefore subject to the normal income tax rules. This means that you remain entitled to your personal allowance (£12,570 for the 2023/24 tax year) even when you retire. Any amount of income you receive over this will be subject to tax at the income tax rate bands:

• 20% for basic tax rate taxpayers with income up to £50,270
• 40% for higher rate taxpayers with income between £50,271 to £125,140
• 45% for additional rate taxpayers with income over £125,140

If you are only receiving the state pension and do not have any other sources of income, then you will not reach the personal allowance threshold. This means you will have no tax to pay. However, if you’re also receiving income from other personal pension funds that you may have, continue to work, receive rental income, or dividends that push you over the personal allowance threshold then you will need to pay tax on any amount over that threshold.

Do I have to pay tax on my personal pension?

As with the state pension, if you are accessing funds from any personal pensions, it will be treated as income and will be subject to income tax once you are withdrawing any amount over the personal allowance. However, unlike the state pension, there are some tax relief options available to you depending on which type of personal pension fund you have and how you choose to withdraw money.

If you have a ‘defined benefit’ pension, which can sometimes also be called a final salary pension or career average pension, it means this type of pension will guarantee you a set amount of regular income from when you choose to retire until the rest of your life. These are rare nowadays but were previously offered by large organisations or public institutions as workplace pensions. How much you will receive is dependent on the pension scheme’s rules, your salary when you were working and how long you were employed for. Usually, the amount increases each year in line with inflation. Depending on the rules of your defined benefit pension scheme, you may be able to take out a lump sum amount or choose to take the entire fund as a lump sum. If you do this, 25% of the amount will be tax-free and the rest will be taxed at income tax rates.

On the other hand, if you have a ‘defined contribution’ pension, the total amount available in the fund to you is limited to the amount that you have contributed and how successfully it was invested by the scheme. This means that there is no guaranteed fixed amount of income for the rest of your life, and therefore careful planning is required to ensure you will have enough for as long as you need. If you do have a defined contribution pension, then you have the following options as to how you can draw down from your funds as well as how you will be taxed:

• Leave your pension untouched at NMPA until a later time when it is needed. If you do this, your entire pot will remain untaxed and can continue to grow if well-invested (bear in mind that, as with all investments, there is no guarantee of profit, and you could end up with less than you put in).
• Use your pension fund to buy an annuity. An annuity is a financial product which guarantees a regular fixed amount of income, either for the rest of your life or for an agreed number of years. You’ll be able to take up to 25% of your pension out tax-free and use the rest to buy an annuity. The regular payments from the annuity will be taxed as earnings where each one falls over the personal allowance.
• Access your pension through flexible pension drawdowns. This is a specific type of way to access funds from your pension pot. You will need to ensure your pension provider allows for this option, or you could switch to one that does. By using flexible access pension drawdown, you have the freedom to choose whether the money you are withdrawing from the pension is from part of your tax-free allowance (25% of your pension fund) or as income. Any amount withdrawn as income will be taxed at the income tax rates.
• Take multiple lump sums out of your pension pot when you need them until you exhaust your pension fund (this is known as uncrystallised funds pension lump sums). Each time you withdraw from your pension pot in this manner, 25% of the amount will be tax-free, whilst the remaining 75% of the amount will be treated as income and taxed at income tax rates.
• Withdraw your entire pension pot in one go. 25% of your entire pension pot will be tax-free whilst the remaining 75% will be taxed at income tax rates. You should consider carefully before doing this as if you have a large pension pot, you’ll attract the higher or additional income tax rates (40% and 45% respectively).

How is tax collected from my pension?

Although the state pension is subject to tax, it will be paid to you without tax being deducted from it. Where possible, HMRC will collect any tax due through PAYE (pay as you earn) sources. This could be from your salary if you are still working whilst collecting the state pension, or from any personal pensions you may be receiving. If you do not receive any PAYE income but are still receiving a combined income from the state pension and other sources (such as dividends or rental income) over the personal allowance you will have to complete a self-assessment tax return in order to declare the tax owed and pay this by 31 January each year.

If all the income you receive after you retire is taxed at source such as income from personal pensions, then you will not need to complete a self-assessment tax return. Instead, your personal pension provider will deduct any tax before paying any income to you. They may well also deduct tax due from the state pension as well through your tax code. At the end of each tax year, you should receive a P60 from your pension provider showing you how much tax has been paid.

Please note that whilst we are unable to provide any financial advice on pension providers or how you should withdraw your pension, we can help should you need any assistance with completing your self-assessment tax return to include your pension income. Make sure you don’t miss out on the other tax advice we can provide.