How is retirement income taxed?
Understanding how your retirement income will be taxed is an important part of developing your retirement income plan. As your employment income is taxed, the same principle applies to your pension income – with income tax deducted at your marginal rate (which is the rate of income tax your next pound would attract). Here, we’ll outline the different options available to access your pension savings and the tax implications for each.
It's important to note that tax treatment depends on your individual circumstances and may be subject to change in future. This information is based on our understanding of current taxation law and HMRC practice, which may change. If you’re unsure about which option to choose or about the tax implications we have listed some sources of help and guidance at the bottom of the page.
1. Cash lump sums
You can take part or all of your full pension pot as a cash lump sum. If you do this, normally 25% of each lump sum payment is tax free, and the remaining 75% is taxed as income. Unless we already hold a tax code for you when you take your first lump sum, you’ll pay tax on an emergency tax code on the taxable portion of the lump sum. You can find more about emergency tax codes on on the government website.
If the use of the emergency tax code means the lump sum is over-taxed, HMRC will refund the over-payment to you at the end of the tax year. Alternatively, you can contact HMRC after you receive the lump sum payment to claim an in-year refund.
2. Annuities
If you decide to buy an annuity, you can normally take up to 25% of your pension pot as a tax free lump sum. If you choose to take this lump sum, your remaining pension funds can be used to purchase an annuity. Income tax will then be deducted from the annuity by your annuity provider, using the tax code provided by HMRC, just as an employer would do with your salary. If you elect not to take the tax free lump sum and use 100% of your pension funds to buy your annuity, all of your income will be taxed and you’ll have given up any entitlement to the tax free portion, so it’s important to seek guidance before making any decisions about your retirement options.
As annuity rates can change substantially and rapidly, there is no guarantee that when you do purchase an annuity, the rates will be favourable.
3. Flexi-access drawdown
You can normally take up to 25% of your pension pot tax free and the rest of your pot can be used for flexi-access drawdown. Flexi-access drawdown lets you keep your pension invested and choose a regular income and/or one-off cash payments. This gives you significant flexibility – you can start, stop or vary your payments to suit your needs and yearly tax position. When you take income withdrawals, your drawdown provider will deduct income tax from your income payments using the tax code provided by HMRC, just as an employer would do with a salary.
The level of income isn’t guaranteed. Drawing income wil reduce the value of your account. You may need to reduce your drawdown income in the future, in particular if investment performance isn’t sufficient or you live to a greater age than originally anticipated. It’s important to review your drawdown account value and level of income regularly.
4. Your money purchase annual allowance (MPAA)
It’s possible to continue paying into a pension plan after you access your pension pot, but the tax limits may change if you do – so you’ll need to plan your actions carefully. The MPAA can be triggered by accessing your benefits flexibly, such as taking a cash lump sum from a money purchase pension plan, taking income from flexi-access drawdown or buying a flexible lifetime annuity. Once you've triggered the MPAA, you can find out how to check if you’ve gone above the money purchase annual allowance.
5. Lump sum allowance and lump sum and death benefit allowance
The lump sum allowance
The lump sum allowance is £268,275. This is the total amount you can take tax-free in your lifetime as pension commencement lump sums (PCLS) and/or the tax-free element of any uncrystallised funds pension lump sums.
Lump sum and death benefit allowance
The lump sum and death benefit allowance is £1,073,100. This is the total amount of lump sums that can be paid tax-free to you during your lifetime, and to your beneficiaries following your death. The following payments count towards your lump sum and death benefit allowance.
- Pension commencement lump sums (PCLS)
- The tax-free element of uncrystallised funds pension lump sums (UFPLS)
- Serious ill health lump sums
- Death benefit lump sums
Once either of the two allowances have been used up any further PCLS payments or payments of any of the other lump sums listed will be subject to income tax at your or your beneficiaries marginal rate.
You might be entitled to higher allowances if you have successfully applied to HMRC for a protected or enhanced lifetime allowance (the lifetime allowance was a limit that applied to pension benefits prior to 6 April 2024).
Sources of information
For more information on how you’ll be taxed in retirement, read the government’s income tax guide.
For general information you can visit MoneyHelper who give free and impartial guidance to help make your money and pension choices clearer.
Pension Wise, a service from MoneyHelper, is a free and impartial government service offering guidance about your retirement options.
If you’d like advice based on your individual circumstances, you should consider speaking to a financial adviser. There is likely to be a charge for this. For help finding a financial adviser local to you please visit MoneyHelper.