Retirement brings many changes to your life situation. Your pension is one of those changes, and your pension payments could even change how you need to deal with taxes. You shouldn’t assume that withdrawing a pension means fewer taxes to pay. Contrary to what people often think, your State Pension is subject to Income Tax. Here is a look at what this means and how much of your State Pension is taxable.
Do You Have to Pay Tax on Your State Pension?
For tax purposes, the Government treats State Pensions as earned income. As such, it is subject to income tax. However, the pension you receive is paid gross, which means that taxes aren’t deducted when the payment is made.
For example, when you receive a salary from your employer, you pay income tax at source. But with State Pension, the taxes you might need to pay are not deducted.
How Much of Your State Pension is Taxable?
Because you don’t pay income tax at source on your State Pension, how do you know how much you need to pay? The amount of tax you have to pay on your State Pension depends on the total amount of income you receive.
For example, potential other income sources include:
- Profits from self-employment.
- Other earnings.
- Other pensions.
- Bank or building society interest.
You have to calculate your total annual income to determine how much tax you pay that year.
Personal Allowance and Your Tax Rate
You should keep in mind that you don’t have to pay any income tax on your gross income up to your personal allowance. Personal allowance in 2020/21 is £12,500. The allowance was the same for 2019/20, but it's always worth checking it out for any annual changes.
If your State Pension and any other taxable income are below the threshold, then you don’t have to pay income tax.
Let’s say your State Pension and other income for 2020/21 is £11,000. That would mean you are below the threshold and you do not have to pay any income tax.
However, any income above the threshold will be subject to Income Tax.
If your State Pension and other income for the year is £50,000, you’ll receive £12,500 of it tax-free, with the remaining £37,500 subject to income tax. You don’t pay tax on your total income; only on income that is above the personal allowance.
Different income tax rates apply depending on the type of income and the total income you earn annually.
During the 2020/21 tax year, the following tax rates apply:
- Basic rate – 20% for £12,501-£50,000 annual earnings.
- Higher rate – 40% for £50,001-£150,000 annual earnings.
- Additional rate – 45% for over £150,000 annual earnings.
With the above example in mind, you would fall into the basic rate bracket, and your £37,500 would be subject to a 20% tax rate. You would need to pay £7,500 in taxes.
What About Other Pensions?
Aside from the State Pension, many people have additional pensions. Taxes are payable on all pension income, not just your State Pension. When you take money from your other pension sources, you will enjoy 25% of it tax-free. You need to pay Income Tax on the other 75%.
Keep in mind that the tax-free amount you receive won’t use up any of your Personal Allowance. If you withdraw £50,000 from a pension, you will receive 25% of it tax-free (£12,500). For the remaining 75%, or £37,500, you would need to pay Income Tax. The amount of tax would depend on your total income for that tax year. If that is all your income for the year, you’d again have to pay the basic rate.
You can find different types of private pensions but all options are essentially taxed the same way. You can have 25% tax-free, and you must pay tax on the rest.
How and When is the Tax Paid?
You build up your State Pension by making National Insurance contributions while you are under the State Pension age. If you are employed, then your employer deducts those payments from your salary. If you work as a self-employed, then you need to make the payments when you file for taxes. These contributions stop once you reach the State Pension age.
When you start withdrawing your State Pension, the tax is not deducted from the payments. If you have other income, HMRC will ask the employer or pension provider to apply a lower tax code to your income payments. The resulting payments will compensate for the lack of tax payments on your State Pension, and you will end up paying the correct tax overall. You won’t need to worry about the tax deduction, as the employer or pension provider will pay the tax on your behalf. HMRC will ask one of those to apply the lower tax code to compensate for the tax if you receive pensions from more than one provider and you don’t work.
At the end of the tax year, you’ll receive a P60 form from your pension provider. It will show how much tax you’ve paid. You can view the form and apply for corrections if necessary.
If you receive any other type of income, such as from Capital Gains, you will be responsible for paying any tax you owe. To do this, you will have to fill a Self-Assessment tax return. This can be done online through the Government portal.
You’ll also have to fill a Self-Assessment return if the State Pension is your only income. Remember that you won’t have to pay any tax on your State Pension if your annual income is below the personal allowance threshold.
For those living abroad, the State Pension is usually tax-free if you’re not a UK resident. If you live abroad but continue to be classed as a UK resident for tax purposes, then the above rules will also apply to you. If you’re not a UK resident, then you might still need to pay tax on your pension income in the country you live in. It’s worth noting that certain countries might not have a double taxation agreement with the UK. If they don’t, then you might have to pay tax in both countries.