I have been taking a fixed income of £500 a month from my pension drawdown pot. I have not changed this amount, yet this month’s income is a lot lower. Why is that?

Florence

Rachel Vahey, AJ Bell Head of Public Policy, says:

Let’s start by looking at how pension income is taxed.

When first taking pension benefits, usually you are able to take up to 25% of your pension pot as a tax-free cash lump sum up to a certain limit known as the lump sum allowance.

The rest will be paid as income – either as drawdown income, a scheme pension or through buying a lifetime annuity.

Generally, the money you take from your pension pot is treated in the same way as income from employment and is taxed like any other earned income you receive.

The only difference between a pension income and a worker’s income is national insurance contributions are never paid on any pension income, even if the person is under the state pension age, which is currently 66 for both men and women. 

The pension or annuity provider will deduct the income tax due on the pension payments through the PAYE system, using the tax code provided to them by HMRC.

If the provider has not yet received a tax code, then they will have to deduct income tax using either the tax code on a P45 form or an emergency tax code. Any overpaid tax can be sorted out, usually by adjusting a future tax code.

Most people also receive a state pension, which does not have tax taken off before being paid out. Instead, HMRC takes it into account when working out the tax code to give to the pension provider to apply to pension income.

Over the last two years, the state pension has increased significantly thanks to the triple lock guarantee and this April the new state pension rises by 8.5% to £221.20 per week which is equivalent to £11,502 a year.

However, the personal allowance – the amount you can earn without paying any income tax – has remained at its current level of £12,570.

This means a bigger share of your personal allowance is being taken up by the state pension, leaving less of the allowance to count against other income including pension income.

The income tax paid on pension income is therefore increasing, meaning a smaller amount being paid out to a pension saver who is on or has opted for a fixed income.

Some may feel disheartened at seeing their regular pension income fall – after all the cost of food, energy, rent and other items is still rising not falling – but this is because they are paying more income tax as their overall income has risen.  

The government has said the personal allowance and other tax thresholds will be fixed up to and including the 2027-28 tax year.

Therefore, the state pension would only need to increase by around 4.5% next year and the year after for it to be worth about the same as the personal allowance by the 2026-27 tax year, meaning all additional income, including from private pensions, would be fully taxed.

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