Is my pension lump sum taxable?
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||Tax Band|
|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|
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.
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.
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
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 is 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|
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.
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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.
|Up to £12,570||Personal Allowance||0%|
|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% tax–free 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% tax–free 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.
Can I take tax-free lump sum from more than one pension?
You can tax a 25% tax-free lump sum from more than one pension, this is because you are still only taking 25% of your pension as a whole. Try and image your pension pots as one large single pension.
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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.
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%|
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.
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Note: Figures quoted in this article are based on tax year 2021-22