Saving into a pension is a fantastic way to boost your long term wealth. You’ll receive pension tax relief on payments into your pension and you won’t pay tax on any income earned within your pension pot. When it comes to drawing your pension you can also take the first 25% tax free.
In this guide we explain everything you need to know about pension tax. We also answer common questions like “do I have to pay income tax on my pension?” and “how do I calculate tax on my pension?”
Do you pay tax on your pension?
When you start drawing your pension, you’ll be able to take the first 25% tax free. The remaining 75% is taxed just like other income. You’ll have to pay income tax but national insurance isn’t due on pension income.
Because tax is calculated annually, it’s important to think about how taking your pension will affect your tax bill. For example, it’s possible that taking a large amount of your pension in one go will push you into paying higher rate tax for that year.
Why is my pension taxed?
Your pension is taxed because it is classed as a type of income. This means your pension will be added to other types of income to work out your total taxable income.
You’ll pay income tax of 20% on all your income once you earn more than your personal allowance of £12,570 per tax year. Higher earners will pay income tax of 40% on any earnings over £50,000.
What tax rate applies?
The income tax rates on pension income are the same as other types of income.
Brits living in England, Wales and Northern Ireland currently have a tax-free personal allowance of £12,570. Amounts earned between £12,570 and £50,000 are taxed at 20% and any income over £50,000 is taxed at 40%.
Tax rates in Scotland are slightly different. There are more tax bands and a higher tax rate of 41% is charged on earnings above £43,662.
How can I avoid paying tax on my pension?
You can’t completely avoid paying tax on your pension but you may be able to minimise the amount of tax due. Here are some tips that may reduce your income tax bill
Take the first 25% of pension income tax free.
Think about spreading out drawing down your pension across several tax years rather than taking it in one go.
If you are still working and can afford to defer your pension, then it may mean you pay less tax in the long run.
Take financial advice on the tax implications of different pension options.
How much tax do I pay on a pension lump sum?
You can withdraw 25% of the value of your pension scheme completely tax free. After this, the remaining 75% will be taxed with income tax when you draw it, just like any other earned income.
Do I pay tax on state pensions?
State pension, any earnings and income from private pensions are all part of your annual taxable income. That means you’ll pay tax on state pensions if your total income is over your personal tax free allowance of £12,570.
How do I pay tax on my private pensions?
Your pension provider will collect any tax you owe on your private and state pension before transferring your pension income. At the end of the tax year you’ll receive a P60 from your pension provider showing what tax you’ve paid.
What about tax on annuities?
Income from annuities is taxed with income tax but not national insurance. Annuity income will be added to any state pension and other income to work out your total taxable income.
Pension lifetime allowance
A pension lifetime allowance is a limit on the total amount you can pay into a pension during your lifetime. If you save over this amount into a pension you’ll trigger an extra tax charge.
At the moment the lifetime allowance is £1,073,000. If you think you might go over this limit then you should get financial advice from an independent financial advisor.
What is emergency tax?
Emergency tax is charged when the inland revenue doesn’t know what your tax code should be. This sometimes happens when you start receiving a new income stream like a pension.
It can mean that you pay too much tax for a while because the emergency tax code is based on you having this new income for the whole tax year.
You will be able to claim back any tax you have overpaid at the end of the tax year.
Pension annual allowance
Your pension annual allowance is sometimes called a money purchase annual allowance. It’s the amount you’re allowed to contribute into your pension each year. Most people have an annual allowance of £60,000 per year. The limit was introduced to stop higher earners getting a huge amount of tax relief on their pension contributions.
Your pension annual allowance may be reduced to £4,000 if you’ve started drawing money out of your pension.
How much tax will I pay on my pension if I am still working?
If you’re still working then all your income will be added together from your work and pension to work out your total taxable income for the tax year.
Is there any other pension tax I should know about?
If you have a very large pension pot of over £1,073,000, then you may have additional tax charges on top of income tax.
How pension tax relief works for employees
Tax relief on pension contributions depends on how your workplace scheme is set up.
There are two different methods of setting up tax relief for employees, gross tax basis and net tax basis. Schemes using the gross tax basis take your pension contributions before any tax is taken from your pay. The net tax basis takes your pension contributions from your net pay, after you’ve paid tax. Tax relief of 20% is claimed and added to the pension scheme at a later stage.
If you’re a higher rate taxpayer and your employer uses the net tax basis then you’ll need to claim the extra 20% tax relief using your tax return. That’s because you are due 40% tax relief on your pension but will only get 20% automatically.
How do I check which pension tax relief method I’m on?
Ask your employer which tax relief method if your pension contributions are taken before or after tax has been paid.
What employers need to know about auto enrolment tax relief
The auto enrolment rules mean that more employers than ever have a workplace pension scheme for their employees. As part of their responsibilities, employers need to make sure the right tax relief is applied to employee pension contributions.
If you’re an employer then you need to decide whether to set up your workplace scheme on a gross or net tax basis. A gross tax basis means that employees will pay pension contributions before they pay tax. A net tax basis means that employees will pay contributions after they pay tax. If you choose the net method, you will need to claim tax relief for your employees at the end of the year.
How to set up pension tax relief correctly
It’s a good idea for employers to check with their accountant that they have set up tax relief correctly. The rules are complicated and you may get a fine if you haven’t set up your scheme properly. Employers need to make sure that they’ve applied the same tax relief settings (gross or net method) to their payroll and pension scheme.
How much pension tax relief will your employees get?
Most employees in England, Wales and Northern Ireland will get 20% tax relief on their pension contributions, but it will depend on their circumstances. Employees’ contributions are capped at a maximum annual allowance of £60,000 per year. Older employees who have already taken money out of their pension may have a lower limit of £4,000.
Higher rate taxpayers may receive more than 20% tax relief on their pension payments. If your pension scheme is set up on a gross basis then they will get 40% tax relief automatically. If you have a net basis scheme then they will need to claim back 20% tax on their tax return. Tax relief for Scottish employees is slightly different as there are more tax bands and higher earners pay 41% on earnings over £43,662.
Did you know that pension saving is one of the quickest ways to grow your wealth? For most of us the rules mean that it will only cost £80 to contribute £160 into our workplace pensions. It’s because any pension contributions you make will get an immediate boost from tax relief and from your employer.
It works like this:
You contribute £80 to your workplace pension scheme.
This is topped up by £20 tax relief, taking your total contribution to £100.
Your employer adds a further contribution of £60 (based on auto enrolment rules).
That means it only costs £80 to pay a total of £160 into your pension.
Bottom line
Building up a decent pension pot takes determination, but generous pension tax rules make it just that little bit easier. Most people will get their pension payments topped up by the government by 20% and they’ll also receive tax free contributions from their employer. It’s also possible to take the first 25% of your pension tax free when you come to retire.
Frequently asked questions
You will have to pay income tax on your pension earnings, but not national insurance.
You are allowed to withdraw the first 25% of your pension without paying income tax. You will pay income tax on the remaining 75% just like other income.
The first 25% you draw out of your pension is tax free.
Tax on pension income is calculated just like any other income. Income from all taxable sources is added together to give a total taxable income. The first £12,570 you earn is tax free; amounts between £12,570 and £50,000 are taxed at 20% and anything over £50,000 is taxed at 40%.
Monthly pension income classed as taxable income so you will need to pay income tax, but not national insurance.
The first 25% you withdraw from your pension is tax free. After that, the remaining 75% is charged income tax but not national insurance.
The tax rules for inherited pensions depend on your partner’s age at death, the type of pension and whether they had started to draw a pension. Generally you will have to pay income tax on an inherited annuity and on drawdown income if your partner was over 75 when they died.
You should get financial advice as the rules are complicated and how you decide to draw your pension could significantly affect your level of tax.
The tax you need to pay depends on your individual circumstances and can change over time. This content is for information only - it's not tax advice. You're responsible for carrying out your own checks and for getting professional advice before making financial decisions.
Alice Guy is a Suffolk-based finance writer, a busy mum of 4 older kids and a self-confessed personal finance geek. She trained as a chartered accountant with KPMG London before working for Tesco Plc as a business analyst. She loves to write about budgeting, saving, investing and building wealth.
Use our simple guide to understand how much state pension to expect, how it’s calculated and if you can boost it.
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