Retirees withdrawing large pension pots are being hit with massive tax bills, as many over 55s remain unclear about the rules.
An analysis by Standard Life found that more than 221 people fully withdrew a pension pot of £250,000 or more between October 2022 and March 2023, facing a tax bill of at least £97,500.
But Mike Ambery, retirement savings director at Standard Life, part of Phoenix Group, issued a warning to those who are tempted to do the same.
He ssaid: “There can be a big cost to not considering tax when you access your pension.
“Many people understandably don’t think about how much tax they’ll need to pay from their pension income. However, it’s important to bear in mind, especially when it comes to the critical moment of accessing pension savings.”
Nearly a third (33%) of those aged 55 and over are not confident in their understanding of how pension withdrawals are taxed, with only 29% feeling confident about their options, according to the research from Standard Life.
How can I access my pension pot?
People have several options for accessing the money in their pension pot, according to Mr Ambery.
Firstly, people could withdraw some or all of their pension pot as a cash “lump sum.” Mr Ambery warned: “Beware of that. Tax charges might apply to reduce the money you receive significantly.”
Or, you can buy an annuity. Mr Ambery said: “It’s an annual income that will be paid to you for the rest of your life. There are many types of annuities available to buy – you should shop around to find the best one that suits you.”
He added: “It’s possible to use part of your pension to buy an annuity, securing a level of income, and leave the rest to access flexibly.”
People can also withdraw money directly from the pension fund while leaving the rest invested through income drawdown.
Alternatively, people can choose a mix of these options.
What are the tax implications of each option?
Mr Ambery explained that retirees have the option to withdraw their entire pension pot as cash, regardless of its size. He noted that 25% of the total amount would be tax-free, while the remaining balance would be taxed as income.
He said: “You can also take smaller sums as cash whenever you need to, and 25% of each sum will be tax-free. Any taxable money you take from your pension will be added to your other income for that year and taxed at the relevant income tax band. It’s important to be aware that this may take you into a higher tax bracket than normal.”
If you choose a flexible income (drawdown) or annuity, the amount of tax you pay depends on your tax band, just like other forms of taxable income. For example, in England, pension income beyond your tax-free cash, between £12,570 and £50,271, is typically taxed at 20%. With drawdown, you can set up a regular income and adjust it whenever you like, including making one-off withdrawals.
Mr Ambery said: “By comparison, an annuity provides a regular income that will only vary if you’ve chosen options like inflation protection.”
Do I pay tax on my state pension?
Your state pension is taxable, but tax isn’t directly deducted. Instead, tax will usually be taken from other income sources that, when combined with your state pension, push your total income above the personal allowance (the amount you can earn tax-free).
Mr Ambery said: “The full new state pension is just over £11,500 in the current tax year, which is less than the standard personal allowance of £12,570. So, this won’t be taxed, but it does count as part of your total annual income.”
From April 1, 2025, the state pension will rise by 4.1% to £11,975 per year, edging closer toward the personal allowance threshold.
Mr Ambery noted that “withdrawals are a complex area” and recommended using resources like the Government’s free Pension Wise guidance service or consulting with pension providers for more detailed advice.
