Working out the tax you have to pay in retirement or semi-retirement is crucial to understanding how much you’ll get to live on. And if you’re combining income from your pension savings with other income, it can be a tricky thing to calculate.

So, let’s take a look at how it works.

The first thing to understand is that income from your pension is taxed like any other income. You received tax relief when you paid into your pension but you’re potentially going to be taxed when you take money out.

However you receive income in retirement – whether from a ‘defined contributions’ (DC) pension pot like a self-invested personal pension (SIPP), or through an annuity (which offers a guaranteed income), or via a ‘final salary’ or defined benefits (DB) occupational scheme, or from the state, or any combination of these – HMRC may want its cut.

What is tax free?

Let’s start with the good news: no National Insurance is due on income that is drawn from a pension, regardless of your age1. For most people in work, that normally represents a deduction of 13.25% from their pay packets2.

In addition, you can withdraw up to 25% of the investments in your DC pension pot as cash and not pay a penny of tax on it.

There is more than one way to do it too because you can take this tax-free money out as one big lump sum or in smaller chunks – all while leaving the rest untouched. And you can do so from as early on as aged 55 (rising to 57 in 2028) – more than a decade before you’re entitled to receive the state pension.

Taking this tax-free cash doesn’t mean you’re necessarily retired or even semi-retired because you can continue to work full-time and continue to get the same levels of tax relief on your pension contributions as everybody else. And you can use the cash however you like and not have to begin drawing a regular (and taxable) income from what’s left in the remainder of pot until you’re ready to do so.

Just remember, though, that withdrawing this tax-free cash inevitably reduces the size of the pension pot that is still invested and is meant to support you once you are fully retired.

Alternatively, you can withdraw an income from your pension as and when it’s needed. Rather than take a tax-free lump sum followed by a regular income, you could take several lump sums, with each lump sum comprising 25% that is tax-free and 75% that is taxable.

Although some pension providers have minimum withdrawal amounts, the Vanguard Personal Pension allows you to withdraw lump sums of any size whenever you please, which is handy if you have other sources of income and want to use occasional lump sums to deal with one-off expenses.

What might you owe?

Everyone is also entitled to an annual tax-free personal allowance, whether retired or working. So if a SIPP was your only source of income, say, you’d be able to withdraw up to £12,570 of taxable income from it in 2022/2023 and not be on the hook to HMRC.

Remember, though, that it’s your total income that counts. If you’re still earning a salary or receiving income from other sources, including a DB pension or annuity, these too will form part of any tax-bill calculations. The state pension also counts as income for tax purposes and at £9,627.80 a year3 is alone more than three-quarters of the personal tax allowance.

In short, if you’ve got several sources of income, the more you withdraw from your pension, the more tax you’ll potentially pay.

So, think hard about how much you really need each year. And if you’re tempted to take all your pension money out just because you can from the age of 55, please consider the hefty tax bill you could face.

Other things to look out for

Another thing to watch out for is emergency tax. When you receive your first payments from your pension provider, you’ll probably be paying tax on them at a higher, emergency rate.

You won’t be taxed at the correct rate until HMRC supplies your pension provider with your tax code. So, remember to claim a tax refund.

But even then HMRC could still get it wrong – especially if you have more than one source of income, each with its own tax code, or taking money out flexibly. It’s more reason to keep a close eye on the tax you are paying4 and another reason to consider bringing all your DC pensions together into a single pot because, in my experience as a financial planner, it improves your chances of being taxed correctly.

As well as save you money, consolidating your pensions can also help you to keep track of your overall retirement savings. This can be especially useful if you’ve saved a very large amount over your career and are worried about breaching the lifetime pension allowance, currently set at £1,073,100. Go above this with your pension savings and you’ll have to pay a higher tax when withdrawing money – 25% on any excess that’s taken as income and 55% if taken as a lump sum.

Keeping the taxman at bay

Once you’ve worked out the optimal amount to take from your pension, what else can you do to minimise your tax bill in retirement?

Well, one thing I would caution against is taking out the tax-free portion just because you can, because unless you have a specific use for the money or are worried about your pension swelling beyond your personal lifetime allowance, you’ll be left with the challenge of having to find a home for it.

You might, for example, be tempted to re-invest your tax-free cash back into your pension because of the extra tax-relief you could earn on it. However, beware as there are rules against recycling pension money in this way and it can result in hefty penalties5.

I have also heard of people reinvesting their tax-free money in an individual savings account (ISA). But what’s the point of doing that if you can enjoy the same degree of tax-free investment growth just by leaving the money invested in your pension?

In addition, there are the death benefits you could lose since ISA investments are part of a person’s estate, which means they can incur inheritance tax on their passing, while pension investments are not.

Flexible pension planning

That said, remember that the ISA savings you have already built up could be a valuable source of tax-free income in retirement. After all, whatever you take out from an ISA doesn’t count as income as far as HMRC is concerned. So every £1,000 withdrawn from an ISA each year, say, would effectively raise your personal tax allowance by the same amount.

It’s why incorporating your ISA savings into your pension planning can potentially boost your options later in life and enable you to enjoy a higher a level retirement income.

Another tip with lump-sum withdrawals is to consider spreading them out over different tax years, to avoid moving yourself into a higher tax bracket in any one year.

At the end of the day, remember that SIPP drawdown is flexible income – it allows you to control your tax bill by adjusting the income you take. So be prepared to adapt to shifting circumstances. This will help to ensure that your pension provides the retirement you deserve.


1 National Insurance also isn’t payable on your work earnings once you’ve reached the state pension age, unless you’re self-employed and paying Class 4 contributions, in which case they stop at the end of the tax year in which you reach this age. However, a separate Health and Social Care levy of 1.25% comes into force from April 2023 that will apply to most workers of all ages.

2 Covers only Class 1 National Insurance contributions for most employed people earning between £823 to £4,189 a month a month as of 2022/23.

3 As of 2022/2023.

4 If you haven’t already, set up a personal tax account to check your records and manage your details with HMRC.

5 For more on this, please consult the ‘Pension tax manual’.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Eligibility to invest in a Vanguard Personal Pension depends on your individual circumstances. Please be aware that pension and tax rules may change in the future and the value of investments can go down as well as up, so you might get back less than you invested. You cannot usually access your pension savings or make any withdrawals until the age of 55.

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Important information

This article is designed for use by, and is directed only at, persons resident in the UK.

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The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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