Pension tax advice

How are pensions taxed?

There are four different ways tax affects your pensions:

• Tax relief on the contributions going in
• Any growth or income within in the pension fund is tax free (similar to ISAs)
• Income tax on your pension withdrawals
• Inheritance tax. Many pension funds can be passed down to future generations without incurring inheritance tax.

How you are taxed on withdrawals can be complicated, as they are taxed as per your marginal rate. When withdrawing funds from your pensions you will usually receive 25% of your pension fund without needing to pay income tax – but you can choose when to take the tax free part of the fund, as one initial tax free pension withdrawal or part of each withdrawal.

You can be flexible when you do decide to take your pension funds. After age 55 you can choose to:

• Take a tax free lump sum of 25% at the beginning of retirement (which was historically taken as a lump sum and the balance of your pension fund then used to buy an annuity)
• Spread your tax free allowance across smaller regular withdrawals. So rather than taking a £100,000 lump sum today, you can take £1,000 a month for the next 100 months plus any growth, and only pay tax on 75% of each withdrawal (assuming no investment losses and no costs and charges apply during the period).
• Take the tax free cash payments, with no tax payable on any of this withdrawal, and defer the taxable payments to a later date.

How much tax do you pay on your pension income?

The tax you need to pay on your pension withdrawals is calculated similarly to income from employment using your marginal rate. In 2024/25 for UK taxpayers (excluding Scotland) this is:

• Personal allowance – £12,570 – exempt from tax
• Basic rate – 20% on income up to £37,700
• Higher rate – 40% on income between £37,700 and £125,140
• Additional rate – 45% on income above £125,140

As Financial Advisers we have cashflow planning tools to help our clients meet their income needs, without paying more tax than they need to. We can visualise their withdrawals, and make sure they don’t take too much income to push them into a higher tax band. This often involves looking at other ways to meet their income needs via ISAs, bonds and other investments, as well as their pension assets.

When you do decide to withdraw funds from your pensions you will usually receive 25% of your pension fund without needing to pay income tax – but you can choose when to take the tax free funds, as one initial tax free lump sum, as regular tax free payments, or as part of each withdrawal.

Tax for semi-retirement

Reducing work hours and being semi-retired, or even returning to work after retiring, may become more popular in future. However, those earning more than £100,000 (in both income and pension withdrawals in one year) should take care, as they will potentially have an effective marginal tax rate of 60% as a result of the loss of their personal allowance. This is just one example where a Financial Adviser can offer their expertise when planning pension withdrawals. It’s all about creating that balance between how you utilise your take tax free cash and your taxable income to meet your overall desired level of income.

For anyone considering phased retirement, they may be more inclined to they take their regular tax free cash while they’re still working and defer the taxable income until they retire fully and may then be in a lower tax band.

Planning your tax free pension allowance

When you’re ready to start taking your pension, you’ll need to decide how much to withdraw, and what to do with the rest. As advisers we need to consider whether a secure income (through annuities and defined benefit scheme pensions) or an unsecured flexible income would be more suitable. Sometimes creating both income streams is needed, guaranteeing some income to meet everyday expenses, and using more flexible options to meet lifestyle and ad hoc spending.

It’s worth noting that drawdown pensions are very useful for estate planning as remaining funds can be passed onto future generations.

Tax relief on pension contributions

With most personally held pension schemes you get your tax relief at source on your own personal contributions – which means that for every £80 that goes into your pension an extra £20 is added on by HMRC automatically.

How can you plan your tax free pension allowance?

At Wren Sterling we use cashflow modelling tools and help you consider various scenarios to ensure you’re better off in the long run, balancing tax efficient today and life expectancy.

For somebody still working, we might structure things so that they take more tax free cash now and defer that potential tax liability to a time when they’re at a lower tax rate or tax band. Therefore the tax burden over their lifetime should be lower.

The value of your investments can fall as well as rise.
The Financial Conduct Authority does not regulate Estate Planning, Tax Planning and Cash Flow Modelling.