Find out how tax works on pensions, savings and additional income, before and after you retire.
Tax on pensions, savings and additional income can be confusing. The way you pay tax depends on the kind of pension you get, and whether you have any other income.
We’ve put together this guide to answer some of your most common questions and give you more information about how some of our processes work.
Understanding how pension funds are taxed is important for planning a good retirement in the UK, where taxes are very complicated. A question that comes up a lot is whether or not pension funds in the UK have to pay capital gains tax. The short answer is no, but there’s more to the story that could have a big effect on how you save for retirement.
The Tax-Exempt Status of UK Pension Funds
In the UK, registered pension schemes get special tax breaks. The fact that they don’t have to pay capital gains tax (CGT) is a big plus for long-term investors. As part of the UK’s “Exempt, Exempt, Taxed” (EET) pension tax system, this exemption is in place.
According to HMRC’s Pension Tax Manual, a registered pension scheme is one that:
- Has been registered under Chapter 2 of Part 4 of the Finance Act 2004
- Has either been registered by HMRC following an application or meets other qualifying criteria
This tax-exempt status means pension investments can grow without the drag of capital gains taxation, potentially leading to substantially larger retirement funds over time.
Understanding the EET System
The UK follows an Exempt Exempt Taxed (EET) approach to pension taxation
- Exempt (E) – Contributions to registered pension schemes receive tax relief (subject to certain limits)
- Exempt (E) – Investment growth within the pension is largely free from income tax and capital gains tax
- Taxed (T) – When benefits are taken in retirement, they’re generally subject to income tax (except for the 25% tax-free lump sum)
This system encourages pension saving by providing tax advantages during the accumulation phase, with taxation deferred until retirement when many people have lower income and potentially lower tax rates.
The Power of Tax-Free Growth: A Practical Example
To illustrate the significant advantage of CGT exemption let’s look at a practical example
Scenario 1: Pension Fund (CGT Exempt)
- Initial investment: £10 million
- Annual growth rate: 10%
- Investment period: 5 years
- Final value after 5 years: approximately £16.1 million
- CGT paid: £0
Scenario 2: Non-Pension Investment (Subject to CGT)
- Initial investment: £10 million
- Annual growth rate: 10%
- Investment period: 5 years
- CGT rate: 15%
- Final value after 5 years: approximately £15.04 million
- CGT paid: approximately £889,000
The difference is striking – an additional £106 million in the pension fund! This demonstrates how powerful the CGT exemption can be over time. The £889,000 saved from CGT continues to generate returns within the pension fund, compounding the benefit.
Taxation at the Distribution Stage
While pension funds don’t pay capital gains tax on their investments, it’s important to remember that the ‘Taxed’ part of the EET system comes into play when you start taking benefits:
- Up to 25% of your pension pot can typically be taken as a tax-free lump sum (pension commencement lump sum)
- The remaining pension benefits are subject to income tax at your marginal rate when drawn
- From April 2015, pension flexibility rules have allowed greater freedom in how benefits can be taken
So, while the fund itself grows free from CGT, you’ll still pay income tax on most of your pension when you eventually access it.
Other Tax Advantages of Pension Funds
Beyond CGT exemption, pension funds enjoy several other tax benefits:
- Tax relief on contributions – Individual contributions typically receive tax relief at your marginal rate
- Income tax exemption – Most investment income within the pension is exempt from income tax
- Inheritance tax benefits – Pensions can often be passed to beneficiaries outside your estate for inheritance tax purposes
- Employer contributions – These aren’t treated as a taxable benefit-in-kind and are free from income tax and National Insurance
Limitations and Considerations
While the tax advantages are significant, there are some limitations to consider:
- Annual allowance – Limits on the amount you can contribute each year with tax relief (£60,000 for most people in 2024/25)
- Access restrictions – You generally can’t access your pension before age 55 (increasing to 57 from 2028)
- Investment risks – The value of investments can fluctuate, potentially impacting your final pension value
- Corporate taxation – Companies that contribute to pension funds still pay corporate taxes, which can indirectly affect contribution levels
Practical Implications for Your Retirement Planning
The CGT exemption has profound implications for retirement planning:
- Long-term investments – The CGT exemption makes pensions ideal vehicles for long-term growth investments
- Asset allocation – You might choose to hold assets with higher growth potential in your pension rather than in taxable accounts
- Tax efficiency – Coordinating pension savings with other tax-efficient vehicles like ISAs can optimize your overall tax position
- Withdrawal strategy – Planning how and when to take benefits can help minimize the income tax payable in retirement
Frequently Asked Questions
Are all pension schemes exempt from CGT?
Only registered pension schemes are exempt. This includes most pension plans at work, personal pension plans, SIPPs, and SSAS plans.
What happens if I transfer my pension to another provider?
Transfers between registered pension schemes don’t trigger CGT liability.
Can I avoid CGT by putting investments into my pension?
While investments in pension plans are not subject to CGT, moving existing investments into a pension plan could result in a CGT liability if their value has grown. Putting money into a pension plan and investing in it is usually a better idea.
What if I move abroad?
The UK tax treatment of your pension may change if you become non-UK resident, and local taxes may apply in your new country of residence.
Do SIPPs (Self-Invested Personal Pensions) also enjoy CGT exemption?
Yes, SIPPs are registered pension schemes and therefore benefit from the same CGT exemption.
The Takeaway: Maximizing Your Pension’s Tax Efficiency
The exemption from capital gains tax represents a major advantage for UK pension savers. Over decades of saving for retirement, this tax benefit can significantly boost your pension pot’s growth potential.
To maximize this advantage:
- Consider consolidating investments within your pension where appropriate
- Review your asset allocation across all investment accounts
- Ensure you’re making the most of available contribution allowances
- Plan your retirement withdrawals with tax efficiency in mind
Remember that while pension funds don’t pay capital gains tax in the UK, you’ll still need to consider income tax on eventual withdrawals. A balanced approach to retirement saving, potentially combining pensions with other tax-efficient vehicles like ISAs, can help you build a tax-efficient retirement strategy.
In this uncertain world, one thing is clear – the tax advantages of UK pension funds, particularly their exemption from capital gains tax, make them a powerful tool for building long-term wealth for retirement. We believe that understanding these benefits can help you make more informed decisions about your financial future.
Telling HMRC about a change in circumstances
From time to time you may need to tell us about changes to your circumstances.
These changes may be minor, such as a change of name or address. However, some changes may impact your financial position. We have support to help you understand these circumstances.
Taxable and tax-free state benefits
Some state benefits are taxable. Read more about tax-free and taxable state benefits.