How the UK Tax System Works

Three taxes that matter in retirement

In brief: Most retirement income is affected by three taxes: income tax, Capital Gains Tax (CGT), and dividend tax. Each has its own rules, allowances, and rates. Understanding how they interact — and how the account you hold investments in changes what you owe — is the foundation of tax-efficient retirement planning.

The UK tax system is layered. Different types of income and gains are taxed in different ways, at different rates, with different annual allowances. In retirement, you typically have several income sources active at once — State Pension, pension drawdown, investment income, possibly rental income — and each one interacts with the others to determine your overall tax position.

Income tax: the foundation

Income tax is the largest tax most people pay in retirement. It applies to:

• State Pension — taxable, paid gross (no tax deducted at source)
• Private pension income — drawdown withdrawals and DB pension payments are taxed as income
• UFPLS withdrawals — 75% of each withdrawal is taxable as income
• Rental income — net rental profit is added to other income
• Employment income — if you continue working in early retirement
• Interest — above the Personal Savings Allowance (£1,000 for basic rate taxpayers, £500 for higher rate, £0 for additional rate)

How the bands work

Income tax operates on a marginal band system. You pay each rate only on the income within that band:

For example, if your total income is £55,000, you pay 0% on the first £12,570, 20% on the next £37,700, and 40% on the remaining £4,730.

How income stacks

The order in which income sources are stacked determines how the Personal Allowance and bands are used:

1. State Pension — uses up most of the Personal Allowance first
2. Pension income (DB, drawdown) — stacks on top
3. Employment income — adds to the total
4. Rental income — stacks next
5. Interest income — sits above other income
6. Dividends — always sit on top of all other income

Because the State Pension (£11,973 in 2025/26) sits just below the Personal Allowance (£12,570), even a small amount of additional income will start being taxed immediately once State Pension starts.

The Personal Allowance taper

For incomes between £100,000 and £125,140, the Personal Allowance is withdrawn at the rate of £1 for every £2 of income above £100,000. At £125,140, the allowance is completely gone.

This creates an effective marginal rate of 60% on income in this range — the standard 40% higher rate plus an additional 20% from losing the allowance. This is the highest effective marginal rate in the UK tax system, and it affects people who might not think of themselves as very high earners.

Capital Gains Tax: on profits from assets

Capital Gains Tax (CGT) is charged on the profit when you sell or dispose of an asset that has increased in value. It is completely separate from income tax and operates on its own rules.

What CGT applies to

CGT applies to gains from:

• Shares and funds held in a General Investment Account (GIA)
• Investment properties (not your main home, which is usually covered by Principal Private Residence relief)
• Cryptocurrency (treated as a capital asset by HMRC)
• Other assets including business interests and valuable personal property

CGT does not apply to gains inside ISAs or pensions — those wrappers shelter investments from CGT entirely.

The annual CGT allowance

Each person has a CGT Annual Exempt Amount — a tax-free threshold below which gains are not taxed. The current allowance is £3,000 per tax year. Gains within the allowance are completely free of CGT.

CGT rates

The rate of CGT depends on your total income for the year:

• 18% for gains falling within the basic rate band
• 24% for gains falling in the higher or additional rate band

Crucially, CGT is stacked on top of income when determining the applicable rate. If your income already fills the basic rate band (income above £12,570), all your gains are taxed at 24%.

How CGT interacts with income

1. Total your taxable income for the year
2. Determine how much of the basic rate band (£12,571–£50,270) remains
3. Gains within the remaining basic rate capacity are taxed at 18%
4. Gains above that threshold are taxed at 24%

This means years with lower income create an opportunity: more of the basic rate band is available for gains, and the CGT rate on those gains is lower.

Dividend tax: on investment income

Dividends from shares and funds are taxed separately from income — though dividends sit on top of all other income when calculating which rate applies.

The annual dividend allowance

Each person has a dividend allowance of £500 per tax year. Dividends within this amount are tax-free.

Dividend tax rates

Above the £500 allowance:

• 10.75% for basic rate taxpayers
• 35.75% for higher rate taxpayers (from April 2026)
• 39.35% for additional rate taxpayers

Because dividends stack on top of other income, a person with £48,000 of pension income has used most of the basic rate band — any dividend income will likely attract the higher rate of 35.75%.

How the wrapper changes everything

The account you hold investments in determines which — if any — of these taxes applies. This is the most important insight in UK tax planning.

ISA — completely tax-free

Everything inside an ISA is sheltered from tax:

• No income tax on interest or withdrawals
• No CGT on gains when you sell
• No dividend tax on investment income
• Withdrawals are completely tax-free at any time

SIPP / pension — tax-deferred

Investments inside a pension grow free of CGT and dividend tax. But pensions are not tax-free — they are tax-deferred:

• Contributions receive tax relief (reducing income tax when you pay in)
• Growth and dividends inside the pension are tax-free
• Withdrawals are taxed as income — 25% is tax-free (the Pension Commencement Lump Sum), and 75% is subject to income tax

The tax saving comes from the difference between the rate of relief on contributions and the rate of tax on withdrawal.

GIA — fully taxable

Everything in a GIA is exposed to UK tax:

• Dividend income above £500 is subject to dividend tax
• Gains above £3,000 are subject to CGT
• There is no sheltering of income or growth

GIAs offer flexibility (no contribution limit, no access restrictions) but at the cost of full tax exposure.

Why withdrawal order matters

Because different accounts have different tax treatment, the order in which you draw from them in retirement significantly affects your total lifetime tax bill.

Consider the same £30,000 withdrawal from different sources:

• From an ISA: no tax due
• From a GIA: may trigger CGT on the gain portion, depending on cost basis
• From a SIPP via drawdown: up to 75% is taxed as income — if combined income pushes into higher rate, the effective rate on that £30,000 could be 40%

Two people drawing the same total income over retirement can pay very different amounts of tax depending on which accounts they draw from and in what order.

Common considerations include:

• Drawing from a GIA before an ISA, to use the CGT allowance efficiently while preserving the tax-free ISA for later
• Keeping pension drawdown low in years when State Pension and other income already fill lower tax bands
• Using Bed & ISA to gradually move GIA investments into the tax-free wrapper using annual CGT allowances

None of these approaches has a universally correct answer — the optimal sequence depends on income levels, account sizes, and each person's specific circumstances.

Putting it together

A practical example illustrates how these taxes interact:

Suppose someone in their late 60s has:

• State Pension of £12,000
• DB pension of £10,000
• SIPP drawdown of £15,000 (75% taxable = £11,250)
• ISA withdrawal of £5,000 (tax-free)
• GIA dividends of £2,000

Total income for tax purposes: £12,000 + £10,000 + £11,250 = £33,250

Income tax: 0% on £12,570, then 20% on the remaining £20,680 = approximately £4,136

Dividend tax: £2,000 dividends, £500 within the allowance, £1,500 taxed at 10.75% = £161 (since income is in the basic rate band and the dividend falls within remaining basic rate capacity)

CGT: If they sell GIA investments with a £5,000 gain — all within the £3,000 allowance, so £2,000 is taxable at 18% = £360

Total tax bill: approximately £4,657 on a gross income of around £40,000.

Replacing the ISA withdrawal with more SIPP drawdown, or timing the GIA sale in a lower-income year, would both change the tax position — without changing the total amount drawn.

These projections are for modelling purposes only. They do not constitute financial advice. Tax rules are subject to change. Please consult a qualified financial adviser before making financial decisions.