Tax on Pension Income

When you come to draw your pension, it will be taxed as income and thus subject to income tax. The amount of income tax you pay depends on your income, as shown below for tax year 2007/2008:

Yearly Income Rate of Tax:

However, income tax is charged only on your taxable income; many people receive some income which is exempt from tax, such as interest from an ISA savings account or state housing benefit. You are also entitled to a certain sum of tax-free income, and your tax-free income allowance is higher once you are over sixty-five years of age. Your total income might therefore not be subject to income tax. Generally your pension will be subject to income tax, but if you receive only the basic State Pension this will not be taxed: the basic State Pension alone is not more than your tax-free allowance. If you continue to work full-time or part-time during your retirement, this income will be taxed according to the Pay As You Earn system, or PAYE, and other taxable income you are receiving may be taxed through the PAYE system via your salary. For more details see State Pension Tax, Non-State Pension Tax and Earning over sixty-five.

Most pension savings schemes will offer you a tax-free lump sum in addition to your regular pension. The total lump sum that you are entitled to will depend on the terms and conditions of your individual pension scheme. Since A-Day however (see A-Day), pension savings schemes are allowed to offer their members a tax-free lump sum of twenty-five percent of their total savings balance upon retirement. Again, the lump sum you are offered depends on your pension scheme.

If your pension fund, that is, your total pension savings in all pension schemes that you contribute to, is under a certain amount, you might be allowed to withdraw your total pension fund as a lump sum. For the tax year 2007/2008 this limit is £16,000. This means that if your total pension savings are £16,000 or less and you are retiring in this tax year, you could withdraw all your savings at once if your pension savings scheme allows you to do so. This practice is known as a ‘trivial commutation’. Trivial commutation of a pension fund on retirement is subject to tax. Twenty-five percent of the pension fund will be tax-free, and the remaining seventy-five percent will be subject to income tax. If for example your total pension fund is £15,000 and you are retiring this year, you would receive £3,750 as a tax-free lump sum and £11,250 would be subject to income tax. After income tax at the basic rate of 22%, you would receive £8,775 of the original £11,250, bringing your total pension lump sum to £12,525. If you choose trivial commutation of your pension fun when your pension is already being paid out, the entirety of this lump sum is subject to income tax. Thus if your pension fund is £15,000 but is already in payment, assuming income tax at the basic rate of 22% your total pension lump sum would be £11,700.