Tax on Pension

Five things you need to know about tax on a pension

How much tax you need to pay on a pension is one of the most frequent questions we get asked. This topic can be confusing.

People worry about how much tax they will have to pay on their pension contributions and on their final pension pot.

It’s important to remember that paying into a pension scheme is a very tax-efficient way of saving for your retirement.

Here are five of the main areas where savings could be affected by the tax on a pension:

  1. Your contributions attract tax relief

Often the thing that makes having a pension really worthwhile is the tax relief.  You get the tax back on any money you have paid into your pension, depending on whether you are a higher or lower rate taxpayer.

HMRC will work out how much your contribution would have been worth pre-tax. When a basic rate tax payer contributes £80, that is £100 before the 20% income tax was applied. Therefore, the Government will pay the difference, £20 tax relief, directly into your pension pot.

If you are a higher rate tax payer or additional rate tax payer you can claim an additional 20% or 25% respectively.  You do need to claim this money though as it won’t be paid automatically.  If you have a workplace pension it might be deducted from your pre-tax pay, in which case you won’t receive this relief as the you’ll never have paid tax on that money.

  1. There are limits on tax relief

You can put however much you want into your pension pot, but there is a limit to the amount of tax relief you can get. *

There are three types of limits you need to know about:

Earnings limits cap the amount of tax relief you can get to the amount you have earned that year.

Higher earners also need to be aware of an annual limit which is generally £40,000 and special limits apply to those who earn over £150,000.

There is also a lifetime limit, currently around £1,055,000 (2019/2020 tax year). This is only likely to affect very high earners.

*Not available if you have already taken an income via drawdown

  1. Your pension pot is taxable

It’s important to know that 25% of money taken from a pension pot is tax free. The other 75% is liable for income tax. The amount of tax you will pay will depend on your total income for the year and your tax rate.

  1. There are two ways to take your tax-free amount

You can take 25% as a lump sum without paying any tax. To choose this option you must also ‘do something’ with the other 75%. There are three options for this, you could choose annuity (where you buy a guaranteed income), take an adjustable income (drawdown) or take the whole pot as cash and pay tax on it.

You can also take smaller sums, whereby 25% of each withdrawal is tax free.

  1. Many factors can affect how much tax you’ll pay

You will still have a tax-free income allowance every year (currently £12,500) subject to earnings limits. This isn’t affected by the tax-free 25% of the pension.

The amount of tax you will pay on the 75% of your pension will depend on your total income and your tax rate. You could also pay Income Tax on;

  • State Pension
  • Earnings
  • Any other income from property or investments
  • All taxable benefits you might be getting

There are various options for maximising the tax efficiency of your pension. It’s therefore important to choose the right one for your personal circumstances.

A financial advisor can help you navigate the minefield around this topic and help you get the retirement you deserve. Get in touch.

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