If you’re looking forward to retirement, it’s good to know the best way to take your money without paying too much tax on your pension savings. Thinking about how you’ll be drawing your pension is an essential part of planning for your retirement. Considering which options are right for you could boost your finances when you choose to stop working, and help bring your plans to life. Here we look at the different ways to access your money.

How are pensions taxed?

As a general rule, when you decide to start withdrawing your pension savings the money is treated in the same way as income from employment and is taxed like any other earned income you receive. However, you have some options on how best to withdraw money to make sure you don’t pay any more tax than you need to. The amount of tax you pay will depend on your individual circumstances, and may be subject to change in the future.

Making decisions about how to finance your retirement is important, so it’s worth shopping around and using available guidance and advice before choosing how to access your pension savings. You can do this through Pension Wise or Unbiased.

Tax on your State Pension

In the UK your State Pension is taxable as earned income, much like your salary. It’s paid ‘gross’ every four weeks - in other words, without any tax deducted. Any tax due is collected from any other source of earned income you have. What’s more, you’ll no longer pay National Insurance contributions when you reach State Pension Age.

You’ll still receive your personal allowance each year. This is the amount of income you can receive before you pay tax. The standard personal allowance is higher than the State Pension, which means you won’t usually pay any tax if this is your only income.

Tax on your personal pension

When you want to access your personal pension savings, the tax you pay could vary depending on the way you choose to withdraw your money.

Tax on your pension lump sum 

You can withdraw money from your pension pot as a lump sum. However only the first 25% is tax-free and doesn’t affect your personal tax allowance. Withdrawing anything more than this is taxable. It’s also added to any other income you have, which could push you into a higher tax bracket.

Tip: If you're keen to take all your pension pot as cash it could mean you will pay a higher rate of tax for that year, so spreading the withdrawals over several years could help to avoid this.

Continue to work and contribute to your pension

If you take no more than your tax-free cash amount, typically 25% of your pension pot, you can still contribute to your pension. You can continue to pay up to your annual allowance of £40,000 each year or 100% of your salary if this is less than £40,000, and benefit from tax relief on your contributions. You may be able to carry forward any annual allowances unused during the three previous tax years.  

Use your pension pot to generate an income

When you’re ready to take an income, there are a few options for using your pension pot:

  • Buy an annuity. An annuity provides a guaranteed, regular income for life, and is paid for by transferring money from your existing pension pot. The money is taxed as earned income, like a salary. You can also choose to receive a guaranteed income for a fixed term with the option of a maturity lump sum at the end of the term.
  • Opt for a flexible income. With income drawdown you leave your pension pot invested and withdraw money when you need it. You can vary how much income you take, which means you can manage the tax you pay. Like an annuity, the money you withdraw is taxed as earned income. Remember, if your pension pot is left invested the value can go down as well as up.

If you want to make contributions into your pension plan after you’ve started taking an income, you’ll be restricted to paying in a maximum of £4,000 each year thereafter. This is referred to as the Money Purchase Annual Allowance (MPAA). You cannot carry forward any unused MPAA from the previous tax year.

TIP: If you’re tempted by the security of an annuity, but also attracted by the flexibility of income drawdown, you can ’mix and match’ and split your money between both.

You can find out how much income you might receive from your pension savings with our handy calculator

Tax on other savings and investments

Increasingly, people are using their personal savings and investments to supplement their pension income in retirement. There are various products you can use, and many attract tax breaks. Here are some of the most common solutions:

  • Savings accounts. If you’re a basic rate taxpayer, you can earn up to £1,000 interest a year without having to pay tax – or you may be eligible for the starting rate for savings, which allows you to earn up to £5,000 interest a year without having to pay tax. Higher-rate taxpayers can earn up to £500 interest.
  • ISAs. You can draw an income from these products tax-free and can pay in up to £20,000 per tax year. There are different types of ISA, so make sure you choose the one that suits your needs. You can take your money out whenever you need it and there’s no limit on how much you can withdraw.
  • Investment bonds. These products are often bought from insurance companies. You usually pay a one-off lump sum, which is invested in fund(s) of your choice. You can withdraw up to 5% of the amount you originally paid each year without incurring a tax charge. If you’re a higher rate taxpayer you may have to pay tax eventually, but not until your total withdrawals exceed 100% of the amount you originally paid in, or you cash in the bond.

If you invest in stocks and shares directly or through a product like a unit trust, the first £2,000 of any dividend income is tax-free. Any withdrawals will only incur a tax charge if your total capital gains exceed the capital gains tax allowance for the tax year in which you take them.

Tip: With a little careful planning it is possible to construct an income from your other savings and investments completely free of tax.

Tax on property income 

Property can be a worthwhile investment in addition to your pension pots. There are several ways to generate money from property to boost your retirement income:

  • Downsizing. If you sell your primary residence and downsize, the money you receive is usually tax-free.
  • Equity release. If you don't want to downsize, but are keen to access the equity in your home, this could be the answer. Like downsizing, the equity you release from your home is currently tax-free. The most common form of equity release is a lifetime mortgage. Remember though, a lifetime mortgage is a loan secured against your home and there may be cheaper ways to access your money.
  • Buy-to-let. Some people are attracted to the idea of becoming a landlord in retirement. Unfortunately, many of the tax breaks available to landlords have been removed. In short, rental income is taxable, although the government’s Rent a Room scheme allows you to let out furnished accommodation in your home and earn up to £7,500 per year tax-free. This allowance is halved if you share the rental income with someone else.

Tip: A drawdown lifetime mortgage means you can take a regular income tax-free. This way the interest charged is less than if you opt for a one-off lump sum.

Find out more

You can visit our pension tax relief page to find out more about how your pension income is taxed in retirement. If you’d like to explore your options at retirement in greater detail download our free guide. And we have more information available about the State Pension too. 

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