HMRC has clarified the tax rules around taking lump sums from your pension, including a "month one" rule that pensioners may want to bear in mind when calculating how much they will have to pay.
A pensioner in their 60s contacted HMRC over social media with a question about their pension payouts, having used up their tax-free lump sum. They were trying to work out how their payments should be taxed. HMRC responded with some general guidance that is worth knowing about when arranging your retirement finances.
Multiple pots rules
On the question of how lump sums work, HMRC explained: "You can take your 25 per cent tax-free pension amount more than once by using phased drawdown or taking multiple smaller lump sums from a single pot, or by accessing multiple separate pension pots."
You can take up to 25 per cent of the value of any pension you hold as a lump sum without paying tax on this. The maximum you can take out in this way across all your pensions is £268,275.
You can make these lump sum withdrawals from the age of 55, as this is the age when you can access and start to draw down from your pension pots. The access age is increasing to 57 in April 2028.
Another rule to note here is that, also from April 2028, the state pension age will go up to 67. The state pension age is in the process of moving up from 66 to 67, going up in stages between April 2026 and April 2028.
How is tax calculated on pension lump sum withdrawals?
HMRC also explained how your lump sum is taxed, should you take out an amount above the 25 per cent limit. The group said: "If you're taking a pension lump sum, the first 25 per cent is tax free and the remaining is taxed on a week 1 month 1 basis."
The idea of a week 1 month 1 tax calculation is that the amount is taxed in isolation, not taking into account any other earnings or tax you have paid that year. You will usually pay income tax at your marginal rate on any lump sum you take out, above the 25 per cent threshold.
Income tax rates
You can earn up to £12,570 each year without paying income tax. Once your income moves above this, you pay:
- 20 per cent - on your income between £12,571 and £50,270.
- 40 per cent - on your income between £50,271 to £125,140
- 45 per cent - on your income above £125,140.
This applies in England, Wales and Northern Ireland. The income tax bands are slightly different in Scotland.
Another rule to note is that once your income moves above £100,000, you start to lose the £12,570 personal allowance. You lose £1 of the allowance for each £2 you earn above £100,000, so you lose it entirely when your income reaches £125,140.
