When it comes to planning for retirement, understanding the tax implications of your pension plan is crucial.
In this article, we break down everything you need to know about SIPP (Self-Invested Personal Pension) income tax, how it works, and how to make the most of your tax-free allowances and reliefs.
To clarify things straight off the bat: you do pay income tax when you withdraw money from your SIPP via drawdown (apart from your 25% tax free cash. But you don’t pay income tax on dividends and interest you earn from your underlying SIPP investments within the wrapper as you would with normal stocks and share holdings.
How does SIPP income tax work?
SIPP income tax is relatively straightforward.
When you start taking money out of your SIPP, you’ll generally pay tax on it just like you would on your regular income, apart from your 25% tax free cash. Let’s dive into the specifics:
The Pension Commencement Lump Sum (PCLS)
The PCLS is the tax-free portion of your pension pot. The first 25% of your pension pot is usually tax-free. You can take this lump sum all at once, or you can take it in smaller amounts over time, depending on your personal circumstances and financial goals.
The Taxable Portion
The remaining 75% of your pension pot is subject to income tax at your income tax bracket.
Your marginal rate depends on your total taxable income for the tax year, which includes not just your SIPP withdrawals but also any other sources of income you have, such as salary, rental income, or dividends.
It’s essential to keep in mind that the amount of tax you pay depends on your overall taxable income for that year. Your pension income may push you into a higher tax band, so it’s worth planning your withdrawals strategically to minimise your tax liability.
Do I Pay Income Tax on Dividends and Interest Within my SIPP?
No, you don’t pay income tax on the dividends and interest you earn from your underlying holdings within your SIPP.
This point often causes confusion, because SIPPs are described as being ‘tax-free’ or ‘tax-efficient’, which they are in some ways – but you do still pay income tax on withdrawals, as explained above.
So, say for example you hold some Tesco PLC shares within your SIPP, and they pay a quarterly dividend to shareholders. You do not have to pay income tax on that dividend, or declare it to HMRC, or put it on your tax return.
Similarly, if you have cash holdings within your SIPP that are generating interest, again, you do not pay income tax on it, and you don’t have to declare it.
This also goes for Capital Gains Tax in a SIPP: when you sell your investments, there is no CGT liability and you don’t have to declare any gains.
However, when you do eventually withdraw any money from your SIPP wrapper, the income is taxable (after your 25% tax free cash as explained above).
For more context, if you hold stocks and shares outside of a SIPP, for example in a General Investment Account, you need to declare any dividends and interest you earn on your tax return as well as any gains made when you sell them. But SIPP investments are sheltered from this type of tax, in the same way that ISAs are.
How much tax do I pay on SIPP drawdown?
The amount of tax you pay on SIPP drawdown depends on your marginal tax rate. Here’s a quick breakdown of the UK tax bands for 2023/2024:
- Personal Allowance: £12,570 – 0% tax
- Basic Rate: £12,571 to £50,270 – 20% tax
- Higher Rate: £50,271 to £125,140 – 40% tax
- Additional Rate: Over £125,140 – 45% tax
Remember, these numbers might change in the future, so always double-check the latest tax bands.
Emergency Tax on First Withdrawals
When you first start withdrawing from your SIPP, your pension provider may use an emergency tax code, which could result in an overpayment of tax.
Don’t panic! You can reclaim any overpaid tax from HMRC, and your tax code should be adjusted automatically for future payments.
Tax Planning Strategies
To minimise your tax liability, consider spreading your withdrawals over multiple tax years, particularly if you have other sources of income that already place you in a higher tax bracket.
At the very least, make sure you’re using your tax-free personal income tax allowance each year (£12,570), as any unused allowance doesn’t roll over to the next tax year.
How much of my SIPP is tax-free?
You can take 25% of your SIPP tax-free.
This is known as the pension commencement lump sum (PCLS).
You can take this lump sum all at once, or you can take it in smaller amounts over time, depending on your personal circumstances and financial goals.
Using Your Tax-Free Cash Wisely
The tax-free portion of your pension pot is a valuable benefit, and using it wisely can make a significant difference to your overall retirement income. Some common uses for tax-free cash include:
- Paying off outstanding debts, such as a mortgage or credit card balances
- Making home improvements or modifications to support ageing in place
- Investing in income-generating assets, such as rental properties or dividend-paying stocks
- Building an emergency fund to cover unexpected expenses or healthcare costs
- Funding a once-in-a-lifetime trip or experience
Remember, everyone’s financial situation and goals are different, so it’s essential to consider your unique circumstances when deciding how to use your tax-free cash.
Can I take 25% of my pension tax-free every year?
No, you can’t take 25% of your pension every year. The 25% tax-free portion of your pension applies to the total value of your pension pot, not the annual withdrawals.
Once you’ve taken the full 25%, any further withdrawals in all years will be subject to income tax.
One option to access your pension tax-free cash and manage your taxable income is through flexi-access drawdown.
This option allows you to take your 25% tax-free cash upfront and then withdraw income from your remaining pension pot as needed.
You have the flexibility to adjust the amount you withdraw each year, which can help you manage your tax liability and make your retirement income last longer.
The Impact of Other Income Sources
Having other sources of income in retirement can affect the amount of tax you pay on your SIPP withdrawals.
For example, if you have rental income or a part-time job, you might already be using some or all of your tax-free personal allowance, which means you’ll pay more tax on your SIPP withdrawals.
Also, if you’re receiving the state pension this will use up most of your personal allowance each year already.
Conversely, if your only source of income in retirement is your SIPP, you may be able to use your full personal allowance before paying any tax on your withdrawals.
What is the difference between a SIPP and a drawdown?
A SIPP is a type of pension plan that allows you to choose your investments, giving you more control over your retirement savings.
Drawdown, on the other hand, refers to the process of taking money out of your pension pot, typically after you’ve reached the age of 55. A SIPP can be in drawdown when you start withdrawing money from it.
Advantages of a SIPP
Some of the key benefits of a SIPP include:
- Greater investment choice and control
- Potential for higher returns due to a broader range of investment options
- Flexibility to adapt your investment strategy as your needs and circumstances change
Do I have to declare SIPP dividends on my tax return?
No, you don’t need to declare any dividends you receive from investments held within your SIPP on your tax return. Dividends within a SIPP are tax-free.
Are SIPP Dividends Tax-Free?
Yes, SIPP dividends are tax-free. This means you do not need to pay tax on the dividends that your investments generate held within your SIPP.
Do SIPPs need to be registered with HMRC?
SIPPs are usually set up and managed by pension providers who handle the registration process with HMRC. As an individual, you won’t need to worry about registering your SIPP yourself.
If you want to claim additional or higher rate contribution tax-relief on your contributions, you’ll need to notify HMRC aobut your SIPP contributions on your tax-return. For more information on this, see our guide to SIPP tax relief.