When you decide to take your pension, you’re likely faced with a range of decisions making the process challenging; one of the areas you need consider is tax.

How and when you choose to access your pension has an impact on the amount of tax you pay. Since the introduction of Pension Freedoms in 2015, those with a Defined Contribution (DC) pension have more flexibility in accessing their retirement provisions. However, research suggests tax paid on income drawn from pension savings has increased in the last three years.

Pension Freedoms is set to generate around £19.2 billion over the next decade, research from the Pensions Policy Institute (PPI) suggests. The study indicates that HM Revenue and Customs (HMRC) has collected at least an extra £1 billion each year since Pension Freedoms were introduced.

The amount someone pays in tax varies widely depending on how they access their savings. So, what tax do you pay on a pension?

You can take a lump sum up to 25% of the total amount built up in a pension tax-free once you’re 55. This money will not affect your Personal Allowance. Further withdrawals beyond this amount will be liable for Income Tax, which will be taken off the remaining amount before you receive it.

You’ll also pay tax on the total annual income you receive that is above the Personal Allowance; this is currently set at £11,850 and will rise to £12,500 from April 2019. Your total annual income is likely to be the combination of multiple sources, such as:

  • Income from a Personal Pension
  • State Pension
  • Earning from employment or self-employment
  • Taxable benefits
  • Returns made from investment, property or savings

The level of tax you pay will be dependent on your total annual income and which tax band you fall into:

  • Basic rate of 20% on taxable income of £11,851 to £46,350
  • Higher rate of 40% on taxable income of £46,351 to £150,000
  • Additional rate of 45% on taxable income over £150,000

The complexity of tax regulations can make it incredibly difficult to understand how much tax you could be liable for. If you’re struggling to decide between the different options for taking your pension, understanding the tax implications can help. But it can be a challenging task.

An example produced by PPI to highlight how different options affect tax liability demonstrates this:

Kirsty retires at State Pension age with the full entitlement to State Pension at £164 per week and DC savings of £260,000.

  • If she withdraws her pension pot in full at State Pension age, Kirsty would need to pay more than £70,000 in tax
  • Drawing down at 7% annually, it’s estimated that Kirsty would need to pay around £29,000 in tax over the course of her retirement
  • If she purchased an annuity with her DC savings, the payment would be around £15,000

With a difference of around £55,000 between the options for Kirsty, choosing a tax-efficient way to access her pension can have a huge impact on retirement plans. Choosing to withdraw her pension in full ultimately means less income over the course of retirement when compared to using Drawdown or an Annuity.

According to PPI: “On aggregate, people currently aged between 50 and State Pension age could pay between £4.6 billion and £13.3 billion more in tax if they chose to withdraw their pots fully at State Pension age compared to if they annuitise.”

While an annuity proves more tax efficient in many cases, according to the PPI research, that doesn’t mean it’s always the right option for you.

It’s not just tax that you need to take into consideration. Opting to access your pension through Flexi-Access Drawdown might mean paying more tax than if you purchased an annuity. But if an annuity isn’t going to provide you with the flexible income needed, the additional tax can make sense.

Like any other retirement decision, deciding how to access your pension is a personal one. It needs to take into account your goals, aspirations, and more, as well as tax implications.

How seeking financial advice can help

Since 2015, more pensioners are choosing not to speak to a financial professional before using a drawdown product. Three in ten (29%) drawdown products are purchased without seeking advice beforehand, compared to 5% before Pension Freedoms were introduced, according to data from the Financial Conduct Authority (FCA).

Financial advice can help you get the most out of your pension savings. As financial planners, we do this in the context of understanding what your wider retirement goals are and how your money will help you achieve these.

If you’re struggling to decide how and when to take your pension, please contact us. We can explain which option is the most tax efficient for your circumstances. Going beyond this, we can also highlight what level of income would be sustainable if you’re using a drawdown product, by using cashflow modelling to demonstrate the impact of life events and more.

Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.

The Financial Conduct Authority does not regulate taxation advice.