Pension changes introduced nearly a decade ago mean that you usually can take money directly out of your pension once you reach the age of 55 (rising to 57 from 2028).
The downside of this flexibility is that if you’re not careful, taking too much out of your pension at once could leave you facing a surprise tax bill.
Here, we look at how much tax you’ll have to pay when you withdraw money from your retirement savings, and how you might be able to reduce your tax bill.
If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased.
Alternatively, if you’re looking for somewhere to start, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.
How much tax will you pay?
When you take money out of your pension – no matter what you do with the money – you can take out a maximum of 25% without having to pay any tax on it. Whatever else you take out of your pension you’ll have to pay tax on.
So, for example, if you have a pension fund of £100,000:
- You can take out up to £25,000 without paying tax on it
- You would pay tax on the remaining £75,000, assuming you cashed in your entire £100,000 pension the day you retired
- You could reduce your tax bill by making use of your personal allowance (the amount of income you can earn or receive without paying tax). In the current year (2014/15), it’s £12,570, and this threshold has been frozen until 2028
- So how much tax would you pay? You’d pay no tax on the first £12,570 (your personal allowance), 20% tax on the next £37,699, which works out at £7,540 in tax and 40% tax on the next £24,729, which works out at £9,892. This would give you a total tax bill of £17,432 for taking all the money out of your £100,000 pension in one go (assuming the first £25,000 was tax-free).
If we assume you also receive the full basic State Pension, which is currently £11,502 a year, you’d pay extra tax on it. Your total tax bill on £111,502 of ‘income’ would be £22,032.80, again assuming 25% of your £100,000 pension is taken tax-free. Find out more about pensions and tax in our guide How much tax will I pay on pension withdrawals?
Reducing your tax bill
If you took money out of your pension in four lots, you could cut the amount of tax you pay considerably.
For example, based on the same £100,000 pension pot, you could take £25,000 out each year. In each case, you’d receive 25% of this tax free. This would mean there would be £18,750 you’d have to pay tax on. You’d also have your £12,570 personal allowance (we’ll assume you’re not getting a State Pension or any other form of taxable income, just to keep things simple). That would leave you with £6,180 that you have to pay tax on each year. Tax at 20% on £6,180 is £1,236.
This sounds ridiculously obvious but we’re going to say it anyway. Once you’ve taken money out of your pension, you have to think about how you want it to generate an income for you. If you just plonk it in a bank or building society account, while interest rates are currently relatively competitive, over the long term you run the risk that your returns won’t keep up with inflation.
Most people take an income from their pension money by moving it into what’s called an ‘flexi-access drawdown’ product – although you don’t have to. Drawdown is a product that lets you keep your pension money invested while allowing you to take income from it. There are risks because if the value of your investments falls, your future income will fall too. Another option is to use some or all of your pension savings to buy an annuity, which will pay you a guaranteed income for life or for a fixed period. If you prefer, you could put your money into something like an ISA instead or another investment, or you can use a combination of these options.
You can take money out of your pension and reinvest it into a pension. The advantage of doing this is that you get tax relief on money you pay in. That means it’s much more of an advantage for higher rate taxpayers than for someone paying the basic rate of tax. But – and it’s a big but – you will only be able to invest up to £10,000 a year into a pension once you’ve already started taking money out of your existing pensions. The government’s done this to stop people ‘churning’ their pensions just to get the tax relief.
Usually in the 2024/25 tax year, you can pay up to £60,000 a year into your defined contribution pension, known as your Annual Allowance. However, once you’ve started taking money out of your pension, the Annual Allowance falls to £10,000, and becomes known as the Money Purchase Annual Allowance (MPAA). Learn more about how the various pension allowances work in our article Understanding your pension allowances.
However, if you only take a 25% tax-free lump sum out of your pension but not any further income, you can still hang onto your full £60,000 Annual Allowance. Read our article Should I take a tax-free lump sum from my pension? to find out more about the pros and cons of taking your 25% lump sum.
Pensions and Inheritance Tax
Pensions are tax-efficient for several reasons, but one of their lesser-known advantages is that they can allow you to pass on money to loved ones when you die without paying inheritance tax (IHT), as your pension isn’t usually considered part of your taxable estate on death.
For example, if you die before you reach the age of 75, your nominated beneficiaries can inherit your pension completely tax-free. If you die after age 75, your beneficiaries will pay income tax on the inherited pension, but only when they come to access the money. Because of this, from an IHT perspective it can often make sense to access your retirement pot last, although of course this will depend on what alternative sources of income you have. Learn more in our guide Can my pension be used to reduce inheritance tax?
If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased.
Alternatively, if you’re looking for somewhere to start, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.
Rest Less Money is on Instagram. Check out our account and give us a follow @rest_less_uk_money for all the latest Money News, updated daily.