Visualise it, and make it happen

Saving for your retirement is one of the most tax-efficient ways of saving there is. But, you still need to be aware of tax when you start to take your retirement savings. Understanding how tax affects your retirement savings is the best way to avoid paying too much tax and get the best value from those savings you’ve worked so hard to build up.

First though – take note

This section covers tax and retirement savings at a high level. But tax is complicated, and the rules change from time to time.

When you’re saving for your retirement, you get tax relief on your pension contributions as long as they’re within the allowances – we covered the allowances in ‘Saving in a workplace pension’. When you take your retirement savings, there’s usually an option to take up to a quarter as a tax-free cash lump sum (up to a maximum of £268,275 in most cases). The rest of your retirement income is potentially taxable.

You don’t have to take any tax-free cash if you don’t want to. It’s simply an option that’s available for you.

In rare cases (if you were a member of a trust-based occupational pension before April 2006 or had Lifetime Allowance protection) you might be able to take more than a quarter of your retirement savings as tax-free cash. If you think this might apply to you, please check with your pension scheme administrator (and it may be worth taking financial advice, which you’d usually have to pay for – see ‘Getting support’).

The table below shows what’s tax-free and what’s potentially taxable when taking your retirement savings. If you haven’t already, you may find it helpful to read through ‘Your options for taking your retirement benefits’ first.

Mind the money purchase annual allowance

This allowance could kick in if you start taking (potentially taxable) benefits out of your retirement savings while you are still saving into a pension. It significantly reduces the amount that can be paid into your pension without a tax charge – the money purchase annual allowance is £10,000, compared to the annual allowance of £60,000. The reduction is designed to discourage people from taking cash out of their retirement savings, then putting it back in with tax relief. Find out more about the money purchase annual allowance here.

You will pay income tax on retirement income that’s over your personal allowance. This applies to any kind of pension, including your State Pension when you start to receive it. The good news is that the tax-free cash options available to you don’t affect your personal allowance – so you can take tax-free cash and still get your full personal allowance in the same tax year.

Income tax is usually deducted from your pension before you get the payment. The exception is State Pension which is always paid to you ‘gross’ (before tax is taken off). If you’re getting other income – whether from work, or other pensions – HMRC will ask your employer and/or pension provider to apply a lower tax code to allow for the fact that no tax has been taken from your State Pension, so you’ll pay the right amount of tax overall. Your employer and/or pension provider will pay the tax to HMRC on your behalf.
If the State Pension is your only income, and the amount you receive is higher than your personal allowance, how you pay tax depends on when you started to receive it.

• Before 6 April 2016 – you’ll need to fill in a self-assessment tax return.
• After 6 April 2016, HMRC will write to tell you how much tax you need to pay.

If you live abroad but are classed as a UK resident for tax purposes, you may have to pay UK income tax on your pension.

If you’re not classed as a UK resident, you don’t usually pay UK tax on your pension, but you might have to pay tax in the country where you live. There are a few exceptions – for example, UK civil service pensions are always taxed in the UK.

If you live in a country that doesn’t have a double-taxation agreement with the UK, you might have to pay tax in both countries. Check HMRC’s double-taxation digest to find out which countries have a double-taxation agreement with the UK and how it works.

1. Don’t try to get at your retirement savings too early.

If you take money out of your retirement savings before age 55, HMRC will treat it as an unauthorised payment and charge you tax, which could be up to 55% of the unauthorised payment. This is a common feature of pension scams. Scammers will try to entice you by claiming there are loopholes that enable you to avoid the tax. There aren’t. You can only get your retirement benefits before age 55 because

• of ill-health,
• you’re in a listed specialist occupation (such as the armed forces, or a professional sportsperson), or
• or if you were in a pension scheme before 6 April 2006 which gave you the right to take benefits before age 55.

2. Mind the money purchase annual allowance.

This allowance could kick in if you start taking (potentially taxable) benefits out of your retirement savings while you are still saving into a pension. It significantly reduces the amount that can be paid into your pension without a tax charge – the money purchase annual allowance is £10,000, compared to the annual allowance of £60,000. The reduction is designed to discourage people from taking cash out of their retirement savings, then putting it back in with tax relief. Find out more about the money purchase annual allowance here.

3. Remember your personal allowance.

You don’t pay tax on any income below your personal allowance. Check here for the current personal allowance.

4. Take care with cash.

You could end up paying a lot of tax if you decide to take some of your retirement savings as a cash amount. For example, if you take £40,000 as cash, £10,000 could be tax-free with the remaining £30,000 could be taxable. And if you have other income in the same tax year, you could be pushed into a higher tax bracket and end up paying more tax than you expected. This pension tax calculator can help you work out how much tax you might pay if you want to turn some or all your retirement savings into a cash amount.