Essentially, your pension acts as a tax shelter for your funds. You don’t pay income tax on the funds you put into your pension or any capital gains tax if your investments increase in value. However, you will need to consider tax when you take money out.
Tax in retirement works in a very similar way to your working life. The tax you pay on your pension is based on your income. Your pension income is how much you take out of your pension pot each year plus any other income.
Also, you need to take into account any income you earn from other sources, how much you withdraw from your pension and your State Pension. All of these added together make up your total taxable income.
Here are the income tax bands in England, Wales and Northern Ireland for 2021/22:
Example 1: A 70-year-old receiving the full state pension and an annuity of £18,000 per year.
The full state pension is around £9,000 and plus the annuity means this pensioner is earning a total of £27,000 per year.
The first £12,570 is tax-free which leaves the next £14,430 taxed at 20%. This means the pensioner is looking at a tax bill of £2,886. This reduces their total income to £24,114 for the year.
Example 2: A 55-year-old wants to withdraw their entire pension pot of £200,000 to pay off the remaining mortgage.
The first 25% is tax-free. The usual personal allowance is wiped out if someone earns over £125,140 so there is tax to pay on the remaining £150,000. Tax will be paid on everything else as below:
Basic rate: 20% of £50,270 = £10,054
Additional rate: 40% on £99,730 = £39,892
Total tax = £49,946!
As you can see, the person taking their pension all in one go loses 25% of their total pension pot in tax!
Careful planning and financial advice are usually required to ensure you don’t end up handing over your hard-earned cash back to the taxman.