As of April 2015, anyone aged 55 or over are entitled to cash in their entire pension pot if they wish. However depending on the size or your withdrawal, you may be required to pay large amounts of tax. As things currently stand, the first 25% of your pension withdrawal is tax free, but the rest is classed as extra income.
Tax on a lump sum
If you have a defined contribution pension, where you've built up a pension by saving over your working life, you can take 25% of the full amount tax free. Assuming that you’re over 55, you can take more if you wish, but tax will be applied to anything over the threshold, based upon the banded-rate of your taxable income.
If you prefer to leave your pension where it is, and instead withdraw smaller amounts on a regular basis, the first 25% of each withdrawal will be classed as tax free.
Tax will be deducted from your withdrawals at source using the PAYE system, making it unnecessary for many people to fill out a self-assessment return. In some cases the pension scheme provider will use an emergency tax code. Emergency tax codes assume that you receive the same amount each month, and therefore treats it as one twelfth of your income. As a result it is likely that you will pay too much tax, and in such cases it is recommended that you actively claim a refund, rather than waiting for HMRC to fix the mistake, which can take months.
Contrary to popular belief, the state pension is not tax free, however the money you receive is paid 'gross' without any tax being deducted. If your taxable income is greater than your tax-free allowance, tax will be applied to your state pension. This will normally be deducted from any private pension you have, or any other payments you receive through the PAYE system. If you have no PAYE income, you'll need to file a self-assessment return and pay any tax due directly to the tax office.
As mentioned previously tax is automatically calculated and deducted from any payments you receive via the PAYE system. As such it's important to ensure that the right tax code has been applied so that you don't pay too much (or too little) tax. For more information see our guide to tax codes. If you do not receive copies of the relevant tax codes, or don't understand how the tax has been calculated, you should contact HMRC for guidance.
For more information on taxable income during retirement please refer to our Guide to Income Tax - Tax on additional income