Pension drawdown tax - everything you need to know

Understanding pension drawdown tax is key to making the most of your income in later life

Understanding pension drawdown tax is key to smart financial planning in later life
Understanding pension drawdown tax is key to smart financial planning in later life
(Image credit: Getty)

Understanding pension drawdown tax is key to smart financial planning (opens in new tab) and lowering your tax bill. This article explains how.

If you’ve reached age 55 and decided to start taking money out of your pension (opens in new tab), there are several things to think about.

The first one is obvious: how much should you withdraw? The next is perhaps not so obvious, but definitely needs some careful consideration. What are the tax implications of accessing your pension?

You may have enjoyed tax relief while you were contributing to your pension, but now you’re taking cash out, the taxman will be looking to take his share.

The good news is the taxman allows you to take 25% of your pension tax-free. The bad news is the rest is subject to income tax. The money you take out of your pension is added to any other income you receive, such as any earnings or your state pension, and taxed accordingly. 

Thinking about pension drawdown tax? Consider what your overall pension income will be

Let’s say you are a basic-rate taxpayer (paying 20% tax) on an annual salary of £45,000 and you have already taken a 25% tax-free lump sum out of your pension. 

If you withdraw £12,000 from your pension, your total income will come to £57,000 and tip you into the higher-rate threshold (£50,000 for tax year 2020-21).

This means £7,000 of your pension withdrawal will be taxed at the higher rate of 40%. The other £5,000 is taxed at 20%. You’d pay a total of £3,800 in tax, therefore keeping £8,200 of your £12,000 withdrawal.

If you instead took out £4,000 a year for three years (a total of £12,000) to stay below the higher-rate tax threshold, you would continue to pay only 20% tax, equivalent to a £2,400 tax bill on the three withdrawals. You’d get to keep £9,600 of your money, which is £1,400 more than if you took it all in one tax year.

So, before you start withdrawing cash from your pot, think about how the money will affect your tax position. Look closely at whether taking money out via pension drawdown could push you into a higher tax bracket. If it does, consider whether you can reduce the withdrawals to stay in the same tax band: you’ll save on tax, plus you’ll have more money left in your pension to potentially grow bigger (opens in new tab) and stretch further.

Taking your tax-free cash gradually 

Another option is to take uncrystallised funds pension lump sums (known as UFPLS, which is often pronounced as “uff-plus”). This is where each withdrawal is 25% tax-free.

This differs from the example mentioned earlier, where you take your 25% tax-free cash upfront (known as the pension commencement lump sum, or PCLS).

Not all pension providers offer UFPLS, so you’ll need to check with yours - or switch to a competitor that does offer it.

With UFPLS, 75% of each pension withdrawal is subject to income tax. This could help lower your annual tax bill, especially compared to the PCLS option where 100% of every withdrawal is liable to tax once you’ve taken the tax-free lump sum. This could be beneficial if you have other income, such as from a rental property or a final salary scheme, and you want to stay within a lower tax band.

On the other hand, there can be more admin involved with the UFPLS approach.

You can only opt for UFPLS if you’ve not already taken any tax-free cash or income from your pension pot.

Emergency tax

When you make a withdrawal from your pension, your pension provider normally takes off any income tax first and you may be put on an emergency tax rate. This is a bit like when you start a new job and sometimes your new employer doesn’t know your tax code so you pay too much tax to begin with.

Say you take £15,000 out of your pension. But your provider doesn’t know that this is a one-off payment, and assumes you’ll be taking out this amount every month. The emergency tax would tax you as if your earnings were £15,000 a month (or £180,000 a year), which would be 45% for an additional-rate taxpayer!

Don’t panic if this happens. It should be resolved by the end of the tax year. Or, you can claim it back more quickly by filling in an HMRC P50 (opens in new tab) (if you’ve stopped working) or P53 (opens in new tab) form (if still working or receiving benefits). You can use this handy HMRC tool (opens in new tab) to check how to claim your tax back.

If drawdown payments are taken regularly then the tax coding should adjust within a couple of months - but again, if you think this is incorrect, get in touch with HMRC.

Do I need to fill in a tax return?

You don’t need to include your tax-free lump sum on your self-assessment tax return. This is because it’s completely tax-free and HMRC does not need to be notified.

If you decide to take UFPLS, tax should be automatically deducted through the pay as you earn (PAYE) system, so a tax return is not needed.

If you’ve taken your tax-free cash, and are now taking money out via drawdown - where 100% of each withdrawal is subject to tax -  the tax should also be automatically deducted via PAYE.

However, when making ad-hoc withdrawals via UFPLS you may find that too much tax is deducted via PAYE. You can reclaim this via a tax return or by sending HMRC a P55 form.

Where your only source(s) of income are paid via PAYE, there is usually no requirement to complete a tax return. Remember, your pension provider normally deducts any tax before a withdrawal is paid under PAYE.

But, where you have other income that is not taxed at source (like self-employment) and you complete a tax return, you must include any UFPLS and/or drawdown payments on the tax return as well.

In the following scenarios, you could be over-taxed at source and the P50, P53 and P55 forms enable you to reclaim any overpaid tax during the tax year:

  • you take your whole pot as a single UFPLS
  • you withdraw the full income drawdown pot in one go
  • you make only a single withdrawal in a tax year (either UFPLS or drawdown)

There may be situations where you think you might have underpaid tax, and in that case you should contact HMRC – it’s likely it will advise you to complete a tax return so it can collect any additional tax owed.

Tax on pensions after you die

Any money left inside your pension when you die is not subject to inheritance tax. However, any cash withdrawn from your pension that you haven’t spent before you die will form part of your estate for inheritance tax (IHT) purposes. 

Everyone can pass on £325,000 IHT-free (or up to £1m if you inherit your partner’s tax allowance and are passing on a family home to children or grandchildren). The remainder is taxed at 40%, or 36% if you leave 10% or more of your assets to charity in your will.

While pensions are not liable for inheritance tax, the person inheriting it may have to pay income tax when they take cash out of it. The exact position depends on your age when you pass away.

If you die before 75, the beneficiary can take all of the money tax-free, as long as they withdraw it - or move it into another arrangement - within two years.

If you die after 75, the beneficiary will pay tax on withdrawals at their highest income tax rate.

Katie is staff writer at The Money Edit. She was the former staff writer at The Times and The Sunday Times. Her experience includes writing about personal finance, culture, travel and interviews celebrities.  Her investigative work on financial abuse resulted in a number of mortgage prisoners being set free - and a nomination for the Best Personal Finance Story of the Year in the Headlinemoney awards 2021.