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How much tax do I pay on my pension?

If there’s one constant in life, it’s paying taxes. And retirement is no exception. Although you may no longer be working, money you receive in retirement as a pension is usually taxable.

When thinking about tax in retirement, it’s important to remember that the incoming changes mean you may end up paying more than you previously thought. Here are a few things to bear in mind when thinking about pension tax.

Lump sums and small pots

When you first retire, you are entitled to take up to 25% of your pension pot as a tax-free lump sum. Under current rules, called ‘Trivial Commutation’, if you have a number of small pots worth less than £30,000 in total, you can take your entire entitlement from age 60, with 25% of it tax-free.  

Alternatively, you can also take up to three pots worth up to £10,000 each as lump sums, again with 25% tax-free.

As of April 2015, the minimum age to take Trivial Commutation lumps sums will be reduced to 55.

Tax planning and fast cars

As of April 2015, the way you can take the rest of your pension is changing, which will have a big impact on the pension tax you may be liable to pay. Instead of individuals being forced to buy an annuity you will be able to take money as and when you need it.  

You can also take your entire pension savings out in one big lump sum to spend as you see fit – as many newspapers have pointed out, you could blow it all on a Lamborghini, for example – although 75% will be eligible for income tax.

Most people don’t pay tax on the first £10,000 they earn – called the Personal Allowance – but depending on how much you take out over the year as income, you will be eligible to pay tax. Aside from any money you take as your tax-free lump sum, if your total income including the State Pension is above the Personal Allowance threshold and up to £31,865, you will pay the Basic rate of income tax, currently 20%.

For amounts over £31,866 but under £150,000, you will usually pay Higher rate of 40%, and amounts over £150,000 will be taxed at 45%. (Note: Tax bands quoted are for the 2014-15 tax year.)

Tax relief or stress?

Whether you are thinking of taking your entire pension pot as a lump sum or as income, it is a good idea to seek financial advice before making any decision.

In some cases, the amount of tax you pay on your income may be higher than the tax relief applied when you paid in to your pension. For example, if you were a Basic rate taxpayer, the government will have paid 20% into your pension savings as tax relief, but if you end up withdrawing an amount that puts you into the 40% Higher rate band, you may lose out.

And remember, you are taxed on your entire income – including the State Pension if you are drawing it.

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This article has been commissioned by retiresavvy and any opinions voiced are the author's own.

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