Income tax

Tax on pensions

By Ian Robinson

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Tax on pensions

Learn about how different income sources are taxed in retirement, and use our handy calculator to work out how much you'd have to pay.

Since April 2015, anyone aged 55 or over has been able to cash in their entire pension pot. But if you were to, say, blow your entire pension on a Lamborghini (£288,795), the tax you'd pay would be enough to buy the Treasury a Porsche (£126,206). And you'd need a pension pot of around £415,000 to start with.   

Which? has created a calculator to show you how much tax you'd pay if you took your whole pot, or a chunk of it, as a lump sum. Further down, we explain the tax on other income sources in retirement.

Tax on a pension lump sum 

From age 55, if you have a defined contribution (DC) pension (where you've built up pension savings over your working life), you can take a 25% lump sum tax-free; you can take more, but you'll pay income tax on anything above 25%. If you leave your pot invested and take out smaller amounts, ad hoc, you'll get 25% of each withdrawal tax-free. Use our calculator to see the tax you would pay. 

Emergency tax on pension withdrawals

Tax on pension-pot withdrawals will be deducted at source, via the pay-as-you-earn (PAYE) system rather than through a self-assessment tax return. In many cases, the scheme provider will need to use an emergency tax code to do this. This code assumes you receive the same amount each month – and treats the sum you receive as one twelfth of your annual income. More tax than is due could therefore be deducted. HMRC will eventually refund the extra, but the process could take months unless you actively claim a refund using the relevant HMRC form - P55, P50Z or P53Z  – in which case it should take no more than four weeks.

If your pension provider already knows your tax code for the year, and the correct amount of personal allowance you should receive, it can use this instead of an emergency code. This means that there is less risk of overpaying tax and having to claim this back.

Tax on state pensions

Contrary to what many people think, the state pension is not tax-free, but the money you receive is paid 'gross' - without any tax being deducted.

If your total income from all sources, including the state pension, is greater than your tax-free allowance, tax is due on your state pension and this will normally be deducted from any private pension or earnings you might have, which are paid through the PAYE system. 

However, if you have no PAYE income, you'll have to complete a self-assessment tax return and pay any tax due directly to HMRC.

Tax on private pensions

Income you receive from private pensions (either directly from an employer's pension scheme or from annuities bought with your pension funds) is paid with tax already deducted via PAYE. 

Your tax office sends your pension provider(s) your tax code so it knows how much to deduct, but it's always advisable to make sure you receive a copy of the code for each source of PAYE income to check your tax. 

If you don't receive copies of all the codes, or do not understand how your tax is being calculated, contact HMRC.

Tax and purchased life annuities

Just like ordinary annuities bought with pension fund money, purchased life annuities are insurance products that you can buy with a cash lump sum and they pay an income for life. But you can buy them at any time, and the tax treatment of purchased life annuities is different from the tax on an annuity you buy with your pension fund. 

Part of the income you receive is treated as a return of your capital and is tax-free. The rest is paid with tax of 20% already deducted. 

  • Last updated: September 2016
  • Updated by: Ian Robinson