The Pension Tax Trap: Allowances, Limits and the 60% Band

Pension tax traps are points in the UK system where paying into or drawing from a pension produces a much bigger tax bill than you would expect from the headline rates. The best-known creates an effective 60% income tax rate on earnings between £100,001 and £125,140, but several others catch people at different stages of retirement planning: the tapered annual allowance for high earners, the money purchase annual allowance triggered by flexible access, emergency tax on your first pension withdrawal, the lump sum allowance across multiple pots, and, from April 2027, the inclusion of unused pension funds in your estate for inheritance tax. The personal allowance is frozen at £12,570 until April 2028, and the full new state pension for 2026/27 now consumes nearly all of it, which means almost every pound of private pension income is taxed from the first pound.

The 60% Trap Between £100,000 and £125,140

The standard personal allowance lets you earn £12,570 before paying any income tax.¹ Once your adjusted net income crosses £100,000, that allowance starts to disappear. You lose £1 of allowance for every £2 you earn above £100,000, under Section 35 of the Income Tax Act 2007.² By the time your income reaches £125,140, the entire allowance is gone.

The result is an effective 60% tax rate on every pound in that band. You pay 40% higher-rate tax on the income itself, and you lose personal allowance worth another 20% in additional tax. On £10,000 of income in this band, you pay £4,000 in higher-rate tax and lose £5,000 of personal allowance that would have sheltered income from 40% tax, costing another £2,000. That is £6,000 of tax on £10,000 of income.

The most direct way out is to reduce your adjusted net income below £100,000. Pension contributions through salary sacrifice are particularly effective because the money never counts as your taxable income in the first place. A personal pension contribution has the same effect: if your salary is £110,000, a £10,000 contribution brings your adjusted net income back to £100,000 and restores the full allowance. Gift Aid donations work similarly, since the grossed-up value is deducted from your income for personal allowance purposes.

If You Pay Scottish Income Tax

Scotland sets its own rates. For 2026/27 the higher rate is 42%, with further bands reaching 45% and 48%.³ The personal allowance taper still applies identically, but the marginal rate on the income itself is higher, so the effective rate on the £100,001 to £125,140 band is above 60% for Scottish taxpayers. The incentive to use pension contributions to bring your income below £100,000 is stronger accordingly.

The State Pension Squeeze on Your Allowance

The full new state pension for 2026/27 is £241.30 a week, roughly £12,548 a year.⁴ Against a personal allowance of £12,570, that leaves about £22 of tax-free space for anything else. Any private pension, part-time work, or savings interest above that margin is taxed at 20% from the first pound.

The state pension is paid gross, so it looks tax-free when it lands in your account. HMRC recovers the tax by adjusting your tax code so that your private pension provider collects it. If you receive £5,000 a year from a workplace pension and £12,548 from the state pension, your provider deducts tax on the combined total exceeding £12,570. Your private pension payments arrive noticeably smaller than expected, because they are carrying the tax bill for income the state paid without deduction. There is no way around this. With the personal allowance frozen until 2028 and the state pension rising each April under the triple lock, the tax-free cushion shrinks every year.

The Tapered Annual Allowance for High Earners

The standard annual allowance for pension contributions is £60,000 in 2026/27. Two income tests then determine whether you get a smaller allowance. Your threshold income (broadly your taxable income minus personal pension contributions) must exceed £200,000 for the taper to be in play at all. If it does, you check your adjusted income, which adds back employer contributions and defined benefit growth. The taper starts at £260,000 of adjusted income.⁵

For every £2 of adjusted income above £260,000, your annual allowance drops by £1.⁶ The floor is £10,000, reached at adjusted income of £360,000. Someone with £300,000 of adjusted income loses £20,000 of allowance, leaving a £40,000 limit for the year.

The blind spot is employer contributions. They count toward the limit, but people routinely forget to include them. If your employer pays in £30,000 and you add another £15,000, that is £45,000 of pension input. On a tapered allowance of £40,000 you have already breached it by £5,000 without realising.

What Happens If You Exceed the Annual Allowance

Contributions above your annual allowance, whether the standard £60,000 or your personal tapered figure, trigger a charge at your marginal income tax rate.⁵ The excess is added to your taxable income for the year. A higher-rate taxpayer pays 40% on the overshoot; an additional-rate taxpayer pays 45%. Because the contribution already received tax relief on the way in, the charge claws that relief back, and you end up worse off than if you had not contributed at all. You report the charge through self-assessment, even if your scheme pays it on your behalf, and the return must be filed and paid by 31 January after the tax year ends.⁷

Scheme Pays

If the charge is large enough, you can ask your pension scheme to pay it directly by reducing your future benefits. This is called scheme pays. In some circumstances the scheme is legally required to offer it (mandatory scheme pays); in others it is discretionary. You must notify the scheme by 31 July following the end of the relevant tax year.⁸ Miss that deadline and you lose the mandatory route, leaving you to fund the charge yourself.

Carry Forward

You can soften a charge by carrying forward unused allowance from the previous three tax years.⁹ The current year’s allowance is used first, then the oldest unused year. You must have been a member of a UK registered pension scheme in each year you carry forward from, and you need enough earnings in the current year to cover the total (employer contributions aside). Carry forward happens automatically at self-assessment; you do not need to tell HMRC in advance. Two common mistakes: assuming you have unused allowance from a year when you were not a scheme member, and trying to carry forward unused money purchase annual allowance, which is not permitted.

The Money Purchase Annual Allowance

Once you flexibly access a defined contribution pension, by taking drawdown income, withdrawing an uncrystallised funds pension lump sum, or emptying the pot, your annual allowance for future money purchase contributions drops permanently to £10,000.¹⁰ This is the money purchase annual allowance, and it applies for life. You cannot carry forward unused amounts from earlier years to increase it.⁹

The trap catches people who dip into a pension early for a short-term need without realising the long-term consequences. A 55-year-old who takes £5,000 from drawdown to pay for home repairs permanently loses the ability to contribute more than £10,000 a year to a money purchase pension, even if they later return to full-time work and want to rebuild the pot. Taking only the 25% tax-free lump sum without drawing income does not trigger the MPAA, and neither does using the small pots exemption for pensions worth under £10,000.¹⁰

Tax Relief Is Capped by Earned Income

Tax relief on pension contributions is capped at 100% of your relevant UK earnings for the year, or £3,600 gross, whichever is higher.¹¹ Relevant earnings means income from employment or self-employment: salaries, wages, bonuses, trading profits. Rental income, dividends, and investment returns do not count.

This trips up people with significant wealth but low earned income. A landlord earning £80,000 a year in rent and nothing from employment can only get tax relief on £3,600 of contributions. Anything above that goes in without the government top-up, which defeats much of the purpose. Early retirees living off savings or investments face the same problem when they want to keep topping up a pension. Relief also stops entirely at age 75, whatever your earnings, so the window for large late-career contributions is finite.

The Lump Sum Allowance Across Multiple Pots

The 25% tax-free cash you can take across your lifetime is capped at £268,275. This is the lump sum allowance. There is also a combined lump sum and death benefit allowance of £1,073,100, which includes tax-free lump sums paid to beneficiaries after your death.¹²

If you exceed the lump sum allowance, your provider deducts income tax from the excess before paying it. Someone with several pots who takes 25% from each can breach the limit without realising, because each scheme only knows about its own payments. HMRC catches up eventually, but the reconciliation at self-assessment can produce an unwelcome bill. If your combined pension pots exceed roughly £1.07 million, keep a running tally of tax-free withdrawals across every scheme.

Emergency Tax on Your First Withdrawal

The first time you take a flexible payment from a pension, your provider will usually apply an emergency tax code. These codes end in M1, W1, or X, and they tell the payroll system to tax the payment in isolation rather than spreading your allowances across the full year.¹³ The system treats a single withdrawal as if you receive that same amount every month.

A one-off £10,000 withdrawal in month one is taxed as though you earn £120,000 a year, pushing you into the higher rate and even into the personal allowance taper. The overpayment is not lost, but reclaiming it takes action. Which form you use depends on the situation:

P55 if you took a partial withdrawal and do not plan to take more before the tax year ends.¹⁴
P53Z if you emptied your entire pot and have other PAYE income such as a job or another pension.
P50Z if you emptied your entire pot and have no other income apart from the state pension.

If you already file self-assessment, you generally have to wait for the tax year to end and reclaim through your return. Either way, HMRC can hold your money for weeks or months. Taking a smaller initial withdrawal, or timing it later in the tax year when the provider has more information about your total income, reduces the overtaxation.

Pension Death Benefits and Inheritance Tax From April 2027

Under current rules, if you die before 6 April 2027, your unused pension funds sit outside your estate for inheritance tax. Scheme trustees decide who receives the money based on your expression of wish, and because the payment is discretionary, it does not form part of your taxable estate.¹⁵

From 6 April 2027, most unused pension funds and death benefits will be brought within the value of your estate for inheritance tax.¹⁵ Trustee discretion will no longer keep them out of scope. For anyone who has been deliberately leaving money in a pension as an inheritance tax shelter, a common strategy since the 2015 pension freedoms, this is a fundamental shift. A large pot that was previously exempt could push your estate above the £325,000 nil-rate band and trigger a 40% charge on the excess. The draft legislation has not yet spelled out how the nil-rate band will be allocated when pensions are included, so the precise interaction with other assets remains uncertain. If your pension is the main tool in your inheritance planning, the 2027 rules deserve a review well before that date.

1
GOV.UK. Income Tax Rates and Personal Allowances
2
Legislation.gov.uk. Income Tax Act 2007, Section 35
3
mygov.scot. Current Rates – 6 April 2026 to 5 April 2027
4
GOV.UK. Benefit and Pension Rates 2026 to 2027
5
GOV.UK. Pension Schemes Rates
6
MoneyHelper. Tapered Annual Allowance Explained 2026/27
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GOV.UK. Self Assessment Tax Returns
8
HM Revenue & Customs. Pensions Tax Manual – PTM056430
9
GOV.UK. Check if You Have Unused Annual Allowances on Your Pension Savings
10
MoneyHelper. Money Purchase Annual Allowance (MPAA)
11
HM Revenue & Customs. Pensions Tax Manual – PTM044100
12
GOV.UK. Tax on Your Private Pension Contributions – Lump Sum Allowance
13
GOV.UK. Emergency Tax Codes
14
GOV.UK. Claim Back Tax on a Flexibly Accessed Pension Overpayment (P55)
15
GOV.UK. Technical Note: Inheritance Tax on Pensions