How Is an Annuity Taxed?

Buying a pension lifetime annuity is one of the ways you can get a regular income in retirement. In exchange for part, or all, of your pension savings, a lifetime annuity will provide an income for life. So you can’t outlive your money.

But how is an annuity taxed?

Like a salary your annuity income payments are classed as ‘earned income’ and are subject to income tax.

In retirement, just as when you were employed, you get an income tax threshold, known as your personal allowance. For 2024-25, the personal allowance is set at £12,570, meaning you do not normally pay tax on any income up to this amount. Beyond this amount, you will need to pay income tax at the relevant income tax rate.

You can usually take a tax-free lump sum of up to 25% of your pension fund. The individual Lump Sum Allowance (iLSA) limits the amount of tax-free cash you can take from all of your pension funds. The maximum amount is £268,275.

What rate are annuities taxed at?

How much tax you’ll pay will depend on your total income. In England, Wales and Northern Ireland this is set at 20% for a basic rate taxpayer. This increases to 40% for higher rate taxpayers and 45% for additional rate taxpayers. If you live in Scotland, income tax bands work slightly differently.

Bear in mind, HMRC will determine your income tax band based on your total income. As well as your annuity income, they will consider any other income sources. This includes your state pension and any income from property rentals, dividends etc. All your income will be added together to determine your tax band.

In addition, your income (and any tax-free lump sum taken) may affect any means tested benefits you receive.

How are annuities taxed to beneficiaries?

When you take out an annuity, you will have the option to add death benefits. These could mean your income or remaining pension funds will be payable to your chosen beneficiaries or estate after your death.

Death benefits can include value protection, a guarantee period or a joint life annuity. If you do not add any death benefits to your annuity, nothing will be payable to your loved ones after your death.

If you have added death benefits and are within the agreed terms, any money left to your estate may be taxed. This depends on how old you are when you pass away:

Before age 75: Lifetime pension annuity payments from value protection, guarantee periods and joint life annuities are tax-free if you as the original annuitant are under 75 when you die.
Age 75 and over: Funds due under value protection, guarantee periods and joint life annuities are subject to income tax at the marginal rate of the recipient if the original annuitant is 75 or over when they die.

Payments under a guarantee period may be subject to inheritance tax if the payments are included in the annuitant's estate and not assigned to a trust. If the annuity amount takes the value of the estate above the £325,000 inheritance tax threshold, tax charges may apply.

The Finance Act 2024 introduces the Lump Sum and Death Benefit Allowance (LSDBA) from 6 April 2024 with a value of £1,073,100.

The LSDBA applies to the non-taxable part of most lump sums paid from a registered scheme. This includes any defined lump sum death benefits insured under a death in service insurance policy.

This means an individual’s LSDBA is reduced each time they receive a relevant non-taxable lump sum from a registered scheme. Following their death any uncrystallised funds and defined lump sum death benefits, as well as any death benefits payable from any other pension savings they may have, will also be tested against the remaining allowance. Any part of the defined lump sum death benefit above the LSDBA, is taxed as income at the marginal rate of the person, or persons, receiving the benefit.

Tax rules and regulations are subject to change and how they impact you will depend on your personal circumstances.

Is all of an annuity taxable?

You can normally take up to 25% of your pension savings as a tax-free lump sum, leaving the rest to buy your annuity. The annuity income you receive after this will be subject to income tax through the pay as you earn (PAYE) system.

How much income will I get from my annuity?

The amount of income you receive from your pension annuity will depend on several factors. These include the size of your pension fund, the features you add to your annuity and your age at the time of purchasing.

The size of your pension pot. As you may expect, the bigger the pension fund used to buy your annuity, the more income you’ll normally receive.
How old you are when you buy your annuity. Purchasing your annuity at a younger age may mean the annuity provider has to pay you an income for longer, resulting in a lower income.
Annuity rates at the time you buy. Annuity rates go up and down depending on market conditions. If annuity rates are on the up when you apply for your annuity, you may be offered a higher income than if rates were low.
Your health and lifestyle. You may be able to get an enhanced annuity if you have certain medical conditions and/or are overweight or smoke.
How you choose to take your annuity payments. You will usually receive a higher annuity income if you choose to take your annuity payments in arrears, rather than in advance. Likewise, if you choose to receive an annually increasing income you will receive a lower annuity payment in the initial years.
Your payment frequency. You may receive more income by choosing to be paid annually in arrears rather than monthly or quarterly.
If you choose to add death benefits. Death benefits can include value protection, a guarantee period or a joint life annuity, each aim to leave something behind after you die. Adding these features to your annuity is likely to reduce the income you receive.

Find out how much annuity income you could get

Want to see how much annuity income you could get? Our online form can help you to compare annuity rates from all providers in the open market.

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The information above is based on our understanding of current tax law including the Finance Act 2024. This sets out how the Lifetime Allowance was abolished from 6 April 2024. The information in this blog doesn’t constitute tax advice. We suggest you seek your own tax or legal advice as appropriate. Tax rules and regulations are subject to change and how they affect you will depend on your personal circumstances.