Is pension income taxable in the UK? State Pension Taxes Explained

Is pension income taxable? Unfortunately, yes, it is. To ensure a comfortable retirement, it is important that you clearly understand how pensions work and what a pension taxed as income means to you personally. Let’s start with your state pension. To find out more, please read on.

Will you pay income tax on your state pension?

A pension taxed as income is a cross we must all bear. Ordinarily, income tax is not deducted at the source. Usually, you will receive the full gross amount each month, and it is up to you to declare it for tax if, over the tax year, your total income exceeds your income tax threshold.

But you must bear in mind that we are talking about your total income, which includes:

• Your state pension
• Other pension payments you receive
• Any earnings from self-employment
• Any receivables from rentals
• Any interest from banks and building societies
• Receivables from investments

You must include income from any of the above-listed elements in a tax year, and the total represents your annual income. The standard income tax on pension UK threshold for the current tax year 2022 – 2023 is £12,570. Anything below this figure isn’t taxable; anything above is.

Is pension tax free?

Unfortunately, pensions are not totally tax-free in the UK. However, some aspects of the UK pension income may be tax-free. For instance, once you reach age 55, which is the age at which you can take funds out from your pension without any penalties, you can take a certain percentage of your pension free as a lump sum.

With regards to the question ‘Is pension income taxable?’, you withdraw a quarter of your pension pot as a tax free lump sum without having to pay income tax. The lump sum payment can only be taken out once, not yearly. After you’ve taken your tax-free lump sum, the remaining pension will be subject to income tax based on your income tax band when withdrawn.

Are other types of pension taxed as income?

To be absolutely clear, income tax is not deducted from your state pension. However, the full new state pension forms part of your total receivables, which is £9.339.20 per annum.

It means that from your personal tax allowance of £12,570, your full state pension (if you receive a full new pension) of £9,339.20 must be deducted, which leaves you with a balance of £3,230.80.

If you have other pensions that will use up this balance and exceed it, you will pay income tax on the excess pension income at the usual rates because the rates don’t change in retirement.

What about national insurance?

You must pay National Insurance contributions during your working life, whether you are employed or self-employed. It starts from the age of 16 and remains a requirement until retirement.

Employed people pay Class 1 National Insurance contributions, whereas the self-employed pay Class 2 contributions weekly at a specific flat rate.

At the end of each tax year, a Class 4 contribution has to be paid, and the amount depends on how much taxable profit has been realised.

The two main types of pensions

Aside from your state pension, the other pensions generally fall into one of two categories – defined benefits pensions and defined contribution pensions. Let’s take a look at how they differ.

Defined benefit pension schemes

A defined benefit pension scheme pays you a retirement income based on your salary plus how long you worked for your employer. These are also referred to as “final salary” and “career average” pension schemes.

You only generally encounter these in older workplace pension schemes or as pension schemes in the public sector. But either type can fall into the bracket of a pension taxed as income if it pushes your annual income over your personal tax allowance.

Defined contribution pension schemes

Defined contribution pension schemes are usually personal or stakeholder pensions. Another name for them is “money purchase” pension schemes. They might be:

• Workplace pensions organised by your employer
• Private pension schemes set up by you

The money paid into these types of schemes is put into investments like stocks and shares by your pension provider. The value of pension pots can appreciate or depreciate depending on how the products they are invested in perform. If you are pondering, ‘Can I have a SIPP and a workplace pension’ yes you definitely can.

With these types of pensions, it’s quite normal for your money to be moved into lower-risk investments as you approach retirement age (currently at 66). If it’s not a built-in feature, you might be able to ask your provider to set it up.

But, is pension income taxable for these types of pensions? These types of pension schemes can come under the umbrella of a pension taxed as income.

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Pension lump sums and taxation

When you and/or your employers pay money into a pension scheme, it forms what is referred to as a pension pot. Once upon a time, you could not access any of your pension pot until you retired. But in 2015, the rules were changed, allowing people aged 55 or over to access as much money as they wanted from defined contribution pension schemes.

It’s no longer mandatory to buy an annuity or put your money into a drawdown scheme. Instead, you can access all or part of your pot. Access to part of your pot will cause the remaining investments to appreciate, but a pension drawdown is required. But taking all of your pot at once can expose you to a major tax bill of 55% income tax.

Most people now take advantage of the 25% lump sum tax-free rule instituted in 2006, taking 25% of their pot without paying any income tax. However, the remaining 75% will be taxed as income under the annual tax threshold rules.

The position with defined benefit schemes is a little more complex. Whereas you still have the option to withdraw 25% as a tax-free lump sum, what happens with a defined benefit scheme is that something called the “commutation factor” comes into play. It is a factor that calculates the amount of income you will receive in retirement after taking a tax-free lump sum upfront.

Pension contributions and tax relief

You get tax relief on the contributions you make to your pension, but the way you claim it depends on the type of pension scheme in question.

The net pay system

Some workplace pensions use the net pay system, and you don’t need to do anything to ensure you get full tax relief. That’s because your pension contributions are subtracted from your salary before income tax is paid, and your pension scheme provider automatically claims back the tax relief at the appropriate rate.

The relief at source system

This system is applied to all types of personal pensions and some workplace pensions. In other words, you should take note if you have a private pension via an insurance company or a SIPP (Self Invested Personal Pension).

If your contributions are made via your employer, they will take 80% of your contributions from your salary. It is referred to as “net of basic rate tax relief.”

Your pension scheme provider then issues a request to HMRC, resulting in an additional 20% tax relief being paid into your Pension. However, with tax relief at source systems, higher or additional rate taxpayers have to fill out a self-assessment tax return form to receive the extra tax relief they are entitled to.

So if you’re asking yourself, ‘do pension contributions reduce your taxable income?’, then the answer is yes, although in some cases, you will have to claim any tax relief over and above the basic rate yourself.

What is pension income taxable UK guidance on declaring lump sums?

When you complete an income tax declaration, you only declare taxable income. So, as far as lump sums up to the value of £25,000 go, they do not have to be declared. However, if you withdraw more than £25,000, you must declare anything over and above that amount.

Can you take tax-free lump sums from several pensions?

Tax-free lump sums are a feature of most pensions. It means that if you have accumulated several pensions during your working career, you will typically be able to take 25% lump sums from each fund, tax-free.

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Pension taxation in Scotland

The income tax bands in Scotland are slightly different from those in the UK. For private pension contributions in England, Wales and Northern Ireland, you can claim additional tax relief on:

• 20% up to the amount of any income on which you paid 40% tax
• 25% up to the amount of any income on which you paid 45% tax

As regards claiming additional tax relief on private pension contributions, you can claim:

• 1% up to the amount of any income on which you paid 21% tax
• 21% up to the amount of any income on which you paid 41% tax
• 26% up to the amount of any income on which you paid 46% tax

Hopefully, we have answered the question of ‘do you pay income tax on pension schemes in England and Scotland?’ to your satisfaction.

As far as private pensions are concerned, you will likely fall foul of the taxman. But it doesn’t have to be that way.

Do I have to pay income tax on my pension if it is an ISA?

ISAs are tax wrappers. However, is pension income taxable on an ISA if it is open as a retirement account? ISAs are a way of investing money without paying Capital Gains or Income Tax on interest or earnings. You don’t have to mention an ISA on your tax return. However, you can claim SIPP tax relief on pension contributions but cannot on ISA contributions.

There are several forms of ISA, but when considering investing for your retirement, the best are probably Lifetime or Stocks and Shares ISAs. Take a look at the different types of ISAs on this page on the Moneyfarm website for more information.

Traditional pensions are pretty challenging to beat, and we are not suggesting that you take out an ISA instead of a pension. Before opening an account, you should look into the SIPP vs ISA debate and consider the pros and cons. However, it’s worth considering investing in one or more ISAs in addition to any private pensions you may already have. It is never too late to get started, just learn how to invest in a SIPP or an ISA.

FAQ

When do I have to pay UK pension income tax?

You have to pay pension income tax in the UK if your pension income (plus other incomes) exceeds your personal allowance.

Can I take my pension as a lump sum?

You can take lump sums from your pension, but this may be subject to income tax. You can only take 25% of your pension as a lump sum without paying income tax. Any amount above the tax-free threshold will be subject to income tax.

Is the state pension taxed in the UK?

Yes, the state pension is a taxable income in the UK. The income tax you will pay on your state pension depends on your total income (other private pensions, work pensions, earnings or investment income). But tax is t deducted after you have been paid and not at the source.