How will a work pension pot worth £9,000 be taxed when I retire?

I have a small company pension worth about £9,000. I am 61 years old and will retire at the end of March.

Today I called my pension company who advised that if I increased my pension to £10,000 I could take out £2,500 over the next four years, and all of this would be tax free as it falls into different tax years.

I then spoke to Pensioen Wijs, who advised me that this information is incorrect and that only the first 25 percent is tax-free. Can you please advise?

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Steve Webb replied: I can understand why you were confused by the seemingly contradictory information you were given. I hope I can clarify what is going on.

Pensioenwijzer has told you that once you reach the age of 55, the starting point is that a quarter of your pension pot can be withdrawn tax-free and that the remainder counts towards your taxable income in the year in which you withdraw it.

This means that if you wanted to withdraw a pension pot of £10,000 at once, you would receive £2,500 tax free and the remaining £7,500 would be taxable income in that year.

However, the actual amount of tax you would pay depends on the other income you had in the same year.

For example, you mention that you are currently working. If you took out the pension pot in full this year, the £7,500 would be added to your wages and you could easily pay tax on the whole amount.

However, your provider suggests that you do something else.

Instead of taking the money all at once, you would wait until you retire and then take “chunks,” where each piece is 25 percent tax-free and 75 percent potentially taxable.

Since you were retired (i.e. no taxable wages coming in) and hadn’t yet reached state pension age (i.e. no taxable state pension income), then that 75 percent would be well within your tax-exempt personal allowance.

This part of your withdrawal is therefore part of your taxable income, but you do not actually pay any tax because it is fully covered by your personal allowance.

However, there are a few other things to think about.

First consider what you will actually live on if you have stopped working and have not received any state pension.

It seems unlikely that you could get by on a £10,000 pension pot spread over four years.

If you receive other income (such as a retirement pension or income from a rental property), this can eat up your personal allowance for that year and means that your share of the own pension will exceed the tax-free allowance and will still be taxed .

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The second interesting thing is that your provider has suggested that you top up your pension up to £10,000.

Apart from the fact that they came close to giving financial advice, I was initially surprised that they linked the option to take a pension in parts to the amount you had in the pot.

However, I have checked your provider’s website and they say the minimum pot size you must have before you can take your pension in ‘flexible chunks’ is £10,000 and this would be why they have suggested to top up before you could go down this route.

One last practical thing to be aware of is that the first time you make a withdrawal, the HMRC may ask your provider to deduct tax using an ’emergency’ tax code.

HMRC does this because they believe you can withdraw a lot of money, which would clearly put you above the tax threshold. But if you only want to make one withdrawal per year, you can fill out a form and get the tax refunded from HMRC.

You should also be aware that once you start withdrawing taxable money from a pot worth £10,000 or more, you will activate a tighter limit on the tax relief you can get on future retirement savings.

If you don’t plan on doing any more retirement savings in the future, don’t worry about it, but if there’s a chance you’ll go back to work and pay a pension again, you should be aware of this.

I have written more about this ‘Annual Money Purchase Allowance’ here.