There is no such as a tax free annuity. However, in a way, everyone can receive a kind of ‘tax free’ annuity, thanks to the tax free lump sum from your pension pot that you can use to purchase an annuity.
Currently you are able to get up to 25% of your pension pot as a tax free lump sum, which can then be used as an annuity fund to invest in an annuity scheme. An annuity scheme turns the lump sum into annual or monthly income during retirement. However, it is important to note that annuity income, which is the income you receive from an annuity provider, is treated as taxable income. This means that although your annuity fund can be tax free, it is not entirely a tax free Annuity, and the income you actually receive from the annuity provider is taxed by HMRC.
The amount is taxed at the appropriate tax band, depending on how much money you receive from the annuity. The annuity provider will deduct the tax before you receive the payment. The fact is that for most pension schemes today – the pension savings need to be converted into an income by investing the money into some investment product. This could be an annuity or an income drawdown plan.
An annuity is where the savings are converted into a regular income and an income drawdown plan is where you withdraw money from the savings as and when you need them. The advantage of an annuity is that although the income is taxed and there is no such thing as a tax free annuity, it is guaranteed for the agreed term of the annuity and you receive it at regular intervals. Depending on the type of annuity you can receive a taxable income for as long as you live, or until the end of a fixed term.
While annuity turns your savings into guaranteed income, income drawdown keeps your savings invested in external investments like stocks and shares, and you can withdraw the money as and when you need additional income. This is also taxable as per the appropriate tax band.
A tax free annuity does not exist in the sense that the income from an annuity is always taxed. However, everybody is entitled to a tax free lump sum from their pension savings which can be used to generate an income during retirement, either through an annuity or through an income drawdown plan.