As you reach retirement age, you may find that you receive income from several different sources, such as private and state pensions, savings and investments. You may also still have income from employment or self-employment if you continue to work.
Much of the income you receive may still have tax due on it, but from age 65, your allowances increase, so long as your overall income is below a certain level, the amount you can receive before you have to start paying tax increases dramatically. This means, with any luck, you should see less of your money disappearing in tax.
However, because your income may come from lots of different sources, it can be difficult to keep track of the tax you need to pay. Here we explain how various types of income are treated for tax purposes:
State pensions
Contrary to what people may think, state pensions are not tax-free, but the money you receive is paid ‘gross’, which means you get it without any tax being deducted.
If your total income from all sources, including state pension, is greater than your tax-free allowance, tax is due on your state pension and this will normally be deducted from any private pension or earnings you might have which are paid through the PAYE system.
However if you have no PAYE income, you’ll have to complete a tax return and pay any tax due directly to HMRC.
Deferred state pension
When you reach state pension age you don’t have to take your pension straight away, but can put it off and boost the sum you eventually receive, or opt for a lump sum.
You might decide to do this if you plan to carry on working, or have other sources of income, such as interest on savings or dividends from investment.
Increase in the pension
Your state pension is increased by 1% for every five weeks you defer claiming it, which means it grows by 10.4% a year. The increased pension income you eventually receive is taxable in the normal way.
If you put off claiming it for at least a year, you can opt to receive a taxable lump sum instead of a pension increase.
If you choose to receive a lump sum instead of a pension increase, this will be taxed at your highest rate of tax in the year you receive it. For 2011-12 this will be either 20% or 40%, depending on whether you are a basic-rate or higher-rate taxpayer.
Lump sum: tax treatment
However, taking a lump sum in this way can’t lift you from basic-rate tax into the higher-rate band, or from being a non-taxpayer into the basic rate and won’t count against you when working out whether you are entitled to higher age-related allowance.
You can also put off receiving the lump sum until the tax year following the year you give up work, which is a good idea if the shift from pay to pension, and corresponding drop in your income, results in you becoming a basic-rate rather than higher-rate taxpayer, since you’ll then pay less tax on the lump sum.
Private pensions
Income you receive from private pensions (either directly from an employer’s pension scheme or from annuities bought with your pension funds) is paid with tax already deducted via PAYE.
Your tax office sends your pension provider(s) your tax code so they know how much to deduct, but it is always advisable to make sure you receive a copy of the code for each source of PAYE income to check your tax.
If you do not receive copies of all the codes, or do not understand how your tax is being calculated, contact HM Revenue & Customs.
Lump sum withdrawal
When you retire, you can draw a lump sum (within certain limits) from your various private pensions tax free. This includes any pension fund built up if you contracted-out of the state additional pension.
If you have only amassed a small pension fund, you can withdraw the whole amount as a lump sum, but part of it will be taxed. This is known as a ‘trivial commutation’ and only applies where you have saved up to £18,000 for 2011-12 in pensions (the limit may change each tax year).
If you have more than one pension, this limit applies to the total, not to each pension. Depending on your income, you may be able to claim some tax back for the element of the lump sum which is taxed. You should ask HM Revenue & Customs for form P53 to make the claim.
Purchased life annuities
Just like ordinary annuities bought with pension fund money, these products pay an income for life, in return for a lump sum.
However, the tax treatment of purchased life annuities is different from the annuity you buy with your pension fund.
Part of the income you receive is treated as a return of your capital, and is tax-free. The rest is paid with tax of 20% already deducted.
