How does tax on pension savings work?
When you are building up savings…
You won’t usually have to pay tax as you save into a pension unless the amount you save into, or build up, over the tax year exceeds the Annual Allowance (or, where applicable, the Money Purchase Annual Allowance).
This means that saving into a pension arrangement is usually tax efficient, as you receive tax relief at your highest marginal rate of income tax.
For example, if you are a basic rate taxpayer, for every £100 you save into a pension, this only costs you £80.
When you retire
From 6 April 2024, a maximum tax-free cash lump sum of £268,275 from all pension arrangements usually applies (some exceptions apply, for example if you have a form of Lifetime Allowance Protection). Read more on the MoneyHelper website.
Please note: if you are moving into a drawdown fund or taking more than one cash lump sum, then you may be able to spread your tax-free cash allowance by taking 25% of each future payment tax-free.
When you’re drawing a retirement income
Once you have taken any tax-free cash at retirement the remainder of your retirement income will be taxed at your marginal rate of income tax as you receive it.
This works in a similar way to the tax you currently pay on your employment income, except you won’t have to pay any National Insurance Contributions.
If you have transferred your benefits and are spreading your tax-free cash by taking 25% of each payment tax-free, then any amount above this on each payment will be taxed at your marginal rate of income tax.
What are the Allowances?
Three tax allowances, or thresholds, that now apply to pension benefits are the Annual Allowance (AA), the Money Purchase Annual Allowance (MPAA) and the Lump sum allowance. The Lifetime Allowance, which was a maximum value of benefits that could be taken from all pension arrangements, was abolished on 6 April 2024.
Remember these allowances are set by the Government and are subject to change.
If you’re not sure on whether any of the above allowances apply to you, we recommend you discuss this with an FCA-registered financial adviser.
Annual Allowance
The Annual Allowance (AA) is the maximum value of pension savings you can build up over a tax year without incurring a tax charge. The Government review and can change this allowance on an annual basis. For the latest information and Annual Allowance figures, please visit this Government website
Lump sum allowance
The most you can usually take as a tax-free lump sum from all pension arrangements is £268,275 – this is known as the lump sum allowance (LSA). If you have lifetime allowance protection, the amount of tax-free cash you can take may be higher.
If you take a lump sum that goes above your LSA, you’ll need to pay Income Tax, at your marginal rate, on the extra amount.
There is also a maximum tax-free amount of £1,073,100, called the lump sum and death benefit allowance, that applies to you and your beneficiaries in certain circumstances. This amount includes any tax-free lump sums payable at retirement and certain lump sum death benefits.
For further information about these lump sum allowances, visit the Government website.
Money Purchase Annual Allowance
The Money Purchase Annual Allowance (MPAA) applies once you have accessed any of your pension savings ‘flexibly’ and taken a taxable income. This includes taking taxable income from a drawdown account, as well as the taxable part of a cash lump sum. It doesn’t apply if you buy an annuity or if you take a small pot lump sum.
Once the MPAA is triggered, this restricts the amount of pension savings you (and your employer) can make into a defined contribution pension arrangement each tax year without incurring a tax charge. For the latest information and MPAA figures, please visit this website: https://www.moneyadviceservice.org.uk/en/articles/money-purchase-annual-allowance
You will need to make sure that you tell any other defined contribution pension arrangements that you are continuing to save and that you are subject to the MPAA so that they can assess your contributions against this lower level.
To assist you with this notification, your pension provider should send you a ‘flexible-access statement’ within 31 days of you first taking a taxable withdrawal. You will then need to let your other pension providers know within 13 weeks of receiving your ‘flexible-access statement’, otherwise you may be subject to a fine.
Therefore, if you are planning to continue working and/or saving into a pension arrangement after taking any of your pension savings, you should take the MPAA into account when deciding which option to take and discuss this with your financial adviser.
What tax will my eligible dependants pay on my death?
The amount of tax your eligible dependants pay depends on how you take your pension savings and how old you are when you pass away.
If you die… |
Annuity |
Drawdown |
cash |
Before age 75 |
If you have bought a joint annuity, which includes a regular income for your eligible dependant following your death, they will normally receive their income tax-free for the rest of their life. |
Your eligible dependants can normally receive the remaining money in your fund as a lump sum or income free of income tax – if the payments start within two years of your death. With effect from 6 April 2027, the amount payable may be subject to inheritance tax. |
Any cash remaining from pension savings you have taken as a cash lump sum will normally form part of your estate for inheritance purposes. |
Age 75 or over |
If you have bought a joint annuity, which includes a regular income for your eligible dependant following your death, they will receive their income for the rest of their life and will normally be taxed at their marginal rate of income tax. |
Your eligible dependants will normally pay tax at their marginal rate of income tax on any savings remaining, whether the account is paid as a lump sum or a regular income. With effect from 6 April 2027, the amount payable may be subject to inheritance tax. |
Any cash remaining from pension savings you have taken as a cash lump sum will normally form part of your estate for inheritance purposes. |
Tax on your State Pension
Income from your State Pension will be taxed at your marginal rate of income tax, in the same way as other retirement income.