How pensions are taxed

In this section we will look at:

• Taxing occupation and private pensions
• The State Pension
• Foreign pensions – the 10% deduction

Taxing occupation and private pensions

Generally pensions are taxed on the same basis as employment income under the PAYE scheme.

Occupational and private pensions will normally have tax deducted ‘at source’ under PAYE (directly by the pension provider). The PAYE code used for your main occupational or private pension will be adjusted to take account of any state pension you receive. This is because the state pension is a taxable income, but does not have tax deducted from it at source (see below).

If you have more than one occupational or private pension, your personal allowance is usually allocated against the main pension.  Any additional pensions are normally  taxed at 20% using a BR (basic rate) code. It the tax code for any of your pensions is wrong, you will pay the wrong amount of tax.

There is general guidance on the taxation of pensions on the HMRC website at http://www.hmrc.gov.uk/pensioners/pension.htm. If you think you could be paying too much tax on your pension, there is guidance on the HMRC website at http://www.hmrc.gov.uk/incometax/overpaid-thro-pension.htm

The State Pension

The Department of Work and Pensions do not deduct tax from your state pension, but it is still taxable.  Instead, the state pension is normally taxed by an adjustment to the PAYE tax code for your private or occupational pension. This means that part of your tax free personal allowance is allocated against your state pension, and this reduces the personal allowance available against your other income.

If an incorrect PAYE tax code is used, then, overall, the wrong amount of tax will be collected. If you have a large state pension and your private or occupational pension is too small to pay the tax due on it and the state pension together, then you might have to complete a self assessment tax return. This would mean that you would have to pay any tax due direct to HMRC.

If you have no sources of income other than your state pension, but your state pension is high enough to produce a tax liability on its own, then you will need to complete a Self  Assessment Tax Return. This could happen because you have a high second state pension. In this case, you will need to put money aside to pay the tax bill due each 31 January. If you do not already receive a tax return, you should contact HMRC to explain that your state pension is large enough to give a tax liability.

Taxing the state pension when you have income which is not taxed at source or under PAYE

If you have untaxed income as well as a state pension, and your total income is more than your tax free personal allowance, you will normally need to complete an annual tax return.  The only exception would be if you have at least one source of income (like an occupational pension) which is taxed at source and is large enough to pay the tax due on all your other income.

You may need to complete a tax return if:

• You have rental income
• You have untaxed savings or investment income e.g. overseas bank interest (UK bank interest normally has 20% tax deducted at source)
• You are self-employed

In these cases you need to pay any tax due direct to HMRC under self assessment. The tax is due on 31 January following the end of the tax year (5 April).

Foreign pensions – 10% deduction

Many pensions paid from overseas to UK residents are only taxed on 90% of the amount payable (the remaining 10% is exempt from tax). These include:

• Pensions due from some Overseas Governments paid in the UK to UK residents. See – http://www.hmrc.gov.uk/manuals/eimanual/EIM74006.htm
• Voluntary pensions etc payable by former employers or their successors. See http://www.hmrc.gov.uk/manuals/eimanual/EIM74500.htm