How much tax will I pay on my pension and how can I avoid it?

If you’re planning for retirement, you may be wondering if your state pension is taxable and whether you pay tax on any pensions.

This guide explores what you need to know about tax and your pensions, as well as how to minimise your tax bill.

Do you pay tax on your pension?

Yes, you’ll have to pay income tax on pension income, just like other kinds of income. You won’t pay national insurance (NI) on pension income because it is only paid on earned income.

You have a personal allowance (£12,570 for the 2024/25 tax year) on which you pay no income tax.

Then you pay 20% tax on income of between £12,571 to £50,270 before higher rate tax of 40% kicks in.

If you earn over £125,140, you pay 45% tax as an additional rate taxpayer.

Find out how much retirement income you might receive (before tax) from your private pension pot and how to boost it by using our pension calculator.

There are some circumstances in which you won’t pay tax on all pension income, and there are also strategies for minimising the amount of your pension lost to tax.

How can I avoid paying tax on my pension?

The way to avoid paying too much tax on your pension income is to aim to take only the amount you need in each tax year.

Put simply, the lower you can keep your income, the less tax you will pay.

Of course, you should take as much income as you need to live comfortably.

Unlike taking a salary, having more income than you need and putting it into a savings account has less advantages.

In most cases, it’s best to leave money inside your pension until you are sure you are going to spend it.

This is where it can be an advantage to use a drawdown scheme.

Drawdown lets you vary your income from year to year, which can potentially lead to tax savings.

If you have an annuity, you won’t have this flexibility, as your annuity income will be at least the same every year.

However, drawdown comes with its own risks.

It’s worth talking to a financial adviser about which option is better for you.

Why is my pension taxed?

You may be puzzled that you have to pay income tax on most of the money taken from your pension.

When you withdraw money from your pension, which is being held by your pension provider, it counts as ordinary income, so it's subject to tax.

How much of my pension is tax-free?

The good news is that some of your pension is tax-free.

If you have a defined contribution pension, you can usually take up to 25% from your pension free of income tax (the remaining 75% is taxed as earnings).

Usually, this is done by taking a quarter of the pot in a single lump sum, but it is also possible to take a series of smaller lump sums, with 25% of each one being tax-free.

So, for example, if you have a pension pot of £60,000 and take the whole pot, only £15,000 will be tax-free – so you’ll pay income tax on the remaining £45,000.

If you take out smaller lump sums, 25% of each will be tax-free, while the remaining 75% of each smaller lump sum will be taxed.

Most defined benefit pensions offer the option of taking a tax-free lump sum as well as a guaranteed (taxable) income. You should ask your scheme for details as you may have a reduced income if you choose to take a lump sum.

It’s a good idea to take financial advice before accessing your pension so you can avoid a huge tax bill.

Learn more: the top 5 places to get free financial advice

Do I pay tax on my state pension?

State pension income is taxable, but whether or not you have to pay tax will depend on your annual income.

Your annual allowance (in the tax year 2024/25) is £12,570, and the maximum new state pension you can receive is around £11,502.40 (£221.20 per week).

So, if your only income is from the state pension, you won’t pay any income tax.

However, if you have income from other sources that push your income over the annual allowance, you will pay income tax on everything above that figure.

Here’s an example. Adam receives the full new state pension and also has an annuity that pays him £8,000 a year.

His total income for the year is £19,502.40. After his annual allowance of £12,570, this leaves £6,932.40 to be taxed at 20% – which is £1,386.48

Adam’s net income after tax is, therefore, £18,115.92.

How is tax paid on my pension?

When you withdraw money from your pension, it’ll already be taxed by your provider using your tax code.

They may also take off any tax that you owe on your state pension via Pay as You Earn (PAYE).

It’s always worth checking that you’ve paid the right amount of tax as emergency tax is sometimes applied to withdrawals.

If this is the case, contact HMRC to get a refund.

Do you pay inheritance tax on pensions?

Inherited pensions are currently free from inheritance tax (IHT), but the rules are changing. 

From April 2027, inherited pensions will be subject to IHT, just like other assets. This is a significant change and could have major tax implications for people with defined contribution pensions. 

Many estates that were previously too small to pay IHT could now end up with a big bill. If you have a defined contribution pension, it’s especially important to get tax planning advice to minimise your tax bill.

Learn more: Pension inheritance: what happens to my pension when I die? 

Can I get a tax refund on my pension?

HMRC refunded a total of £44 million to people who overpaid tax when they flexibly accessed their pensions in the third quarter of 2024.

Overpaying tax usually happens when an emergency tax rate is applied to a lump sum withdrawal from a pension.

If you’ve overpaid tax, contact HMRC or fill out a P53 or P53Z form to get a refund.

Can I work while drawing my pension?

You can work and earn money while drawing any kind of pension, whether it’s a workplace, personal or state pension.

But bear in mind that earning while drawing your pension will likely increase your tax bill.

How much tax will I pay on my pension if I am still working?

You will have the same personal allowance and tax bands, so all income over £12,570 will be taxed at the normal rate (at least 20% unless some of your non-pension income is from dividends, which may be taxed at a different rate).

If you’ve started withdrawing taxable income from your pension, the amount you’ll be able to pay in and get tax relief will likely fall – this is known as the money purchase annual allowance (MPAA).

Will I pay tax on my pension lump sum and if so how much?

You can take 25% of any pension pot as a tax-free lump sum (the remaining 75% is taxed).

However, it is possible to cash in an entire pension pot as a single lump sum.

Be warned, though: unless the pension pot is very small, this is almost always a bad idea from a tax point of view.

The money you receive will count as income for just that year and will be taxed accordingly.

It may even push you into a higher tax band (resulting in 40% tax or more).

In short, you could cancel out any tax benefits from having the pension in the first place.

The only times it may make sense to withdraw a whole pension pot is when the pot is very small – e.g. a workplace pension from brief employment.

It may still be better to transfer it to your main pension, though, but it's worth getting financial advice.

There’s more useful information here on different ways to draw your pension.

Get expert financial advice

Understanding the tax implications of your pension is crucial for maximising your retirement income. By strategically managing your withdrawals and staying informed about tax rules, you can minimise the amount lost to taxes.

Whether you’re planning your retirement or already enjoying it, being proactive about your pension tax can ensure a more comfortable and financially secure future.

Let Unbiased match you with a financial adviser for expert financial advice on managing your pension withdrawals and minimising your tax liability.