How is my pension taxed?
Normally, any pension paid to you is treated as earned income and may be liable to income tax.
Pensions and income tax
Pension income paid to you is normally treated as earned income for income tax purposes, although you don’t pay any National Insurance contributions on your pension income. But bear in mind that you will normally be able to take some of your pension benefits (typically up to 25% of the value of your pension) as a tax free lump sum at outset.
How much will you pay?
The amount of income tax that you may pay depends on your gross taxable income (the total amount of income potentially liable to tax that you receive). You do not pay any income tax if your gross income does not exceed any personal allowance you may have (the standard personal allowance for the tax year 2021/22 is £12,570). HM Revenue & Customs (HMRC) should tell you how much your personal allowance is each time it changes.
If your gross income is more than your personal allowance, you are liable to pay income tax on the amount that exceeds the personal allowance. Different rates of income tax apply depending on the type of income and how much it is. If you’re receiving pension income, your pension provider will normally calculate how much tax you are liable for, using your tax code, and deduct this tax before paying the balance across to you.
If you receive your pension income, including any State Pension you receive, from more than one source, each provider is given a tax code for the income they pay you. This allows them to calculate how much tax they should deduct and pay to HMRC on your behalf.
Things you should check
You should check each year that the correct amount of income tax has been deducted from the pension payments you receive, especially if you have other sources of income, such as a part-time or full-time job, bank or building society interest and/ or dividends or distributions from investments.
If you have had more tax deducted than you should have paid, you can reclaim the difference from HMRC. Similarly, you may also have to pay any tax that has been underpaid. If you need to reclaim tax when you’ve stopped working you can fill in claim form P50 and send this to HMRC. Alternatively, if you fill in a Self Assessment tax return you can make the reclaim via this return.
If you’re a member of a defined contribution pension scheme and you’re looking to draw retirement benefits, you may have full flexibility on the amount that you can receive. This may include up to the total amount of your pension pot.
However, you should be aware that if you take substantial amounts from your pension pot you could become liable to pay higher rates of income tax (potentially up to 45% of the amount withdrawn, 46% in Scotland) so you may receive substantially less than the value of your pension pot.
What tax is payable on pensions when someone dies?
If you inherit an income drawdown fund on the death of an individual who was under aged 75 when they died, any income you take from the fund will be tax-free and if you decide to buy an annuity with the remaining fund from an insurance company, the annuity paid to you will be tax-free.
If you receive an annuity on the death of an individual who was under aged 75 when they died, the annuity paid to you will be tax-free.
If an individual dies at age 75 or over any remaining pension can be taken by beneficiaries as an income or lump sum at their marginal rate of income tax.
If you receive a dependants’ pension paid from a defined benefit scheme this will be taxed at your marginal rate, regardless of the age of the individual when they died.
I am a member of a defined benefit workplace pension scheme, why can’t I choose how much income I can withdraw from my scheme?
The Government has decided that the majority of the pension reforms announced in the 2014 Budget only apply to defined contribution pension schemes. There are some ongoing consultations and the situation may change in the future.
Based on the question above, is there anything I can do for more flexibility?
Currently, it's possible to transfer defined benefit pension schemes to a defined contribution pension scheme. This would allow you to benefit from the new flexibility, but you may be giving up valuable guaranteed pension benefits both for yourself and any financial dependants you may have. You should take financial advice before proceeding with any transfer of benefits. Please contact us if you want to discuss the implications.
Since 6th April 2015, it hasn't been possible to transfer an unfunded public sector defined benefit pension scheme to a defined contribution scheme. It will still be possible to transfer private sector or funded public sector defined benefit pension schemes but you will have to receive financial advice before you can transfer if the value of your benefits is over £30,000.
Where can I find out more?
If you need more information, please contact us. A pension specialist from our team will be happy to help with whatever pensions-related question you have. Our help is always free.