Pension Advice

Is My Pension Lump Sum Taxable? – What You Need To Know

is my pension lump sum taxable graphic

A pension is a tax-efficient way to put money aside for later in life, to provide income for when you retire. At age 55 you can access your pension and take a lump sum, which may be subject to income tax. Here we answer some of the common questions around taking a tax-free lump sum.

 

Generally, the first 25% of your pension lump sum is tax-free. The remaining 75% is taxable at the same rate as income tax. The tax-free lump sum does not affect your personal allowance.

 

In this post, we will break down some of the details which will affect how much tax you pay on your lump sum.

 

How much income tax will I pay on my pension lump sum?

 

The amount you’re taxed on a pension depends on your personal income.

 

Your tax-free personal income allowance is £12,570. If you have already earned over the allowance, then you’re liable to pay income tax on everything exceeding this amount.

 

The amount of tax depends on which income band you qualify for. The table below shows income tax bands in the UK. This does not include Scotland where the tax bands are slightly different.

 

Income Rate Tax
Up to £12,570 Personal Allowance 0%
£12,571-£50,270 Basic Rate 20%
£50,271-£150,000 Higher Rate 40%
Over £150,000 Additional Rate 45%
Table 1: Shows income bands and tax rates in the UK. Source: https://www.gov.uk/income-tax-rates.

 

If your personal income exceeds £100,000 per year, your personal allowance maybe slightly lower. The personal allowance is reduced by half of the amount – £1 for every £2 over £100,000.

 

Your pension provider will be able to work out how much tax you must pay for the current tax year using your tax code.

 

Pension Withdrawal Amount Income For The Year Tax Paid
£100,000 0 £17,432
£100,000 £30,000 £30,432
£500,000 0 £153,710
£500,000 £30,000 £167,210
Table 2: Shows examples of tax paid depending on income. Source: Which.com/money/pensions-retirement-calculators

Note: Table figures have been updated for the 2021-22 tax year. It’s advisable to take tax advice from a qualified accountant.

 

The table above shows that if you made a pension lump sum withdrawal of £100,000 you’d need to pay £17,432 in tax (assuming you’ve received no additional income that tax year). The examples below give more detail about how the tax liability is calculated.

 

Example 1:

  • Pension pot = £100,000
  • Tax free lump sum = £25,000
  • Additional income for tax year = £0

Taxable income is = £75,000

  • Tax paid at 20% = £7,540
  • Tax paid at 40%: = £9,892
  • Tax paid at 45%: = £0
  • Total tax paid = £17,432

Total income after tax = £82,568

 

Now let’s look at a different example assuming the individual withdrawing from their pension has earned £30,000 in additional income for the tax year.

 

Example 2:

 

  • Pension pot = £100,000
  • Tax free lump sum = £25,000
  • Additional income for tax year = £30,000

 

Taxable income is = £105,000

 

  • Tax paid at 20%= £7,540
  • Tax paid at 40% =£22,892
  • Tax paid at 45%= £0
  • Total tax paid= £30,432

Total income after tax = £73,054

 

Can I take 25% of my pension tax-free at 55?

 

Yes, you can usually take your pension from age 55 (age 57 from 2028).

 

If you have a defined contribution pension (a workplace or private pension) you can take 25% of your pension as a tax-free lump sum.

 

If you have a defined benefit (DB) pension, often known as a ‘final salary’ pension, the situation becomes more complicated. Again, you can generally take a lump sum when you reach 55. However, how much you might receive in one go as a cash lump sum and how much your yearly income would be reduced by in the future, is determined by what’s known as a scheme’s ‘commutation factor.’

 

A common commutation factor is 15. In this case you’d reduce your annual pension income by £1,000 to get a £15,000 cash lump sum.

 

How can I avoid paying tax on my pension lump sum?

 

If you have a defined contribution pension you can usually take 25% of your pension as tax-free cash. You can avoid paying unnecessary tax by taking your pension in a series of smaller lump sums. This is because each year you are allowed to take £12,570 without paying tax (your standard personal allowance).

 

For example,

 

You have a pension pot of £100,000

 

£25,000 is tax-free (25%) and the remaining £75,000 is taxable

 

You take the remaining £75,000 as six equal amounts of £12,500 spread over six years

 

As this falls within your standard personal allowance, and if you’ve no other taxable income during this time, you won’t pay any income tax.

 

Only taking the amount of tax-free cash you need at the time is potentially a good idea, as by leaving the rest in your pension, it’s got a chance to grow tax-free, and you could end up with a greater tax-free sum overall. Only taking the amount of tax-free cash you need at the time is potentially a good idea as by leaving the rest in your pension, it’s got a chance to grow tax-free, and you could end up with a greater tax-free sum overall.

 

However, when taking your pension in smaller lump sums you must also factor in any additional income, as this could end up putting you in a higher tax bracket meaning you’ll pay more income tax.

 

What are 25% tax-free lump sum pension rules?

 

Defined contribution pension

 

With a defined contribution pension scheme (workplace or private pension) you can usually choose to take some or all your pension pot as a lump sum. 25% of this will be tax-free.

 

The tax-free lump sum doesn’t affect your personal tax allowance. The remaining 75% is then taxed as income at your marginal rate of tax, based on your total taxable income for the tax year.

 

If you take your 25% tax-free lump sum, you must pick one of the options below for the remaining 75%.

 

Your pension options How much is tax free? What’s Taxable
Guaranteed income (Annuity) 25% of your pension pot before you buy an annuity Income paid from the annuity
Adjustable income(Pension Drawdown) 25% of your pot before you invest in an adjustable income Any income you get from your investments
Take cash in smaller chunks 25% of each small chunk you withdraw 75% of each small chunk you withdraw
Take your whole pot in one go 25% of your whole pension pot 75% of your whole pension pot
Mix of different options from above Depends which option you choose Depends which option you choose
Table 3: Shows different pension options and taxable amounts.

 

Defined benefit pension

 

With a defined benefit scheme (often called a final salary pension) the pension and lump

sum are separate, and you’ll draw your pension and take your cash lump sum at the same time. The amount you can take as a lump sum will be set by the scheme.

 

How much can I earn before paying tax on my pension?

 

The standard personal income allowance in the UK is £12,570 you can earn this amount before having to pay tax. Income from a pension is classed as personal income, so only withdrawing up to your personal allowance in a tax year, means you won’t be liable to pay income tax. Income from a pension is classed as personal income, so only withdrawing up to your personal allowance in a tax year, means you won’t be liable to pay income tax.

 

It’s worth considering that earnings from property, interest on savings over your savings allowance, or money taken from a pension pot are all classed as personal income and therefore will be subject to income tax based on the rates below.

This does not include Scotland where the tax bands are slightly different.

 

Income Rate Tax
Up to £12,570 Personal Allowance 0%
£12,571-£50,270 Basic Rate 20%
£50,271-£150,000 Higher Rate 40%
Over £150,000 Additional Rate 45%
Table 4: Shows income bands and tax rates in the UK. Source: https://www.gov.uk/income-tax-rates

 

Do I have to declare my pension lump sum on my tax return?

 

You must provide all taxable income on your tax return. The 25% you’ve taken tax-free doesn’t need to be included, however the remaining 75% does.

 

Can I take a tax-free lump sum from more than one pension?

 

If you have more than one pension scheme you can usually take a cash lump sum from each one, with up to 25% of each amount tax free.

 

Note: According to HMRC guidelines, if this lump sum is paid from more than one pension fund, you must: have your savings in each scheme valued by the provider on the same day, no more than 3 months before you get the first payment.

 

Should I take my 25% taxfree lump sum?

 

Taking your 25% cash lump sum payment gives you complete control over your money allowing you the flexibility to spend or invest it as you wish. On the other hand, any amount you don’t take as a lump sum has the potential to continue to grow tax free in your pot and will remain protected from potential inheritance tax.

 

It’s a good idea to have a plan and know what you want to spend your lump sum on and when you want to spend it, that way you can take only what you need, when you need it. This avoids any surplus sitting in a savings account when instead it could be invested, potentially growing your overall pot for you over the long term.

 

How many times can you take 25% taxfree cash from your pension?

 

You can take a cash lump sum from your pension in one go or in several smaller amounts. Up to 25% of each lump sum will be tax-free.

 

Depending on the type of pension you have, you may not have to take your cash lump sum all in one go. You could take it in smaller chunks; for each withdrawal, up to 25% is tax-free, with the rest charged at your normal income tax rate.

 

Is it better to take a lump sum or monthly pension?

 

Taking a lump sum cash payment gives you complete control over your money allowing you the flexibility to spend or invest it as you wish. A monthly pension will give you a regular income, like a salary.

 

If you choose to take your tax-free lump sum but don’t want or need to use the remaining pot of money as a regular income, you can choose to keep it invested.

 

You can then make withdrawals (which will be taxed as income) from this as and when you’re ready. This is known as pension drawdown.

 

It’s important to keep an eye on your investments. There is potential for growth, but the value of investments and income can go down as well as up.

 

Alternatively, if you want a regular income from your pension you can opt to buy an annuity with the remaining funds once you’ve taken your lump sum. This provides a guaranteed regular income for the rest of your life or agreed term.

 

With lump sum and drawdown options, it’s important to be mindful of how long the funds need to last. If you take out too much too quickly you could run out of money.

 

Take a closer look at the pros and cons of all these options in our useful video guide.How To Retire On Your Terms

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How is a defined benefit pension taxed?

 

With a defined benefit pension (also known as a final salary pension) you can usually take 25% of your pension tax free from age 55. The ongoing payments from the pension will be classed as taxable income.

 

Do I pay tax on my state pension?

 

State pension is taxable but the amount you pay will depend upon your income for the tax year. Your tax-free personal income allowance is £12,570. Everything exceeding this amount will be taxed. The amount of tax you’ll pay depends on your total income for the year and your tax rate.

 

Is a pension lump sum classed as income?

 

Yes, a pension lump sum is classed as income and will be added to your income for the tax year, meaning you could change tax bands. However, the first 25% is generally tax-free.

 

How much can a retired person earn without paying taxes in the UK?

 

A retired person in the UK can earn up to £12,570 in a tax year without paying tax. Income received from taxable sources including pensions, property and savings exceeding this amount will be taxed at the standard rates shown in the tables below.

 

How much tax will I pay on my pensions in Scotland?

The income tax bands are slightly different in Scotland than in the UK. This means the tax you pay on pension withdrawals is different. The table below shows taxable income bands in Scotland.

 

Band Taxable Income Scottish Tax Rate
Personal Allowance Up to £12,570 0%
Starter Rate £12,571 to £14,667 19%
Basic Rate £14,668 to £25,296 20%
Intermediate Rate £25,297 to £43,662 21%
Higher Rate £43,663 to £150,000 41%
Top Rate Over £150,000 46%
Table 5: Shows Scottish income rate tax bands

 

Want to know if taking a tax-free lump sum is right for you?

 

Deciding whether to take your tax-free lump sum is a big decision that can impact your retirement plans.

 

To make sense of your pension options and get started on your journey to retirement, you can take our free no-obligation meeting.

 

You tell us what you want to do, you tell us your goals and aspirations, and then we start your journey to retirement.

 

Retirement Savings – how much you need to save for retirement

 

Retirement Date – when you can afford to stop working and start enjoying financial freedom

 

Retirement Income – how much you can spend in retirement without worrying you’ll run out

 

So, if you’re looking to make sense of pension and retirement planning options with

straightforward financial planning advice, we’re here to help.

 

Contact our friendly team on, 033 0133 3035 or use the form below to arrange a free call back from one of our experts.

 

Joslin Rhodes Pension & Retirement Planning – Real Advice, For Real People

 

Joslin Rhodes Pension & Retirement Planning is authorised and regulated by the Financial Conduct Authority (FCA).

 

Note: Figures quoted in this article are based on tax year 2021-22

 

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