No one wants to pay more tax than they need to at any stage of life, but it’s particularly important to avoid paying too much tax on your pension when drawing down on your savings.
The key to reducing how much tax you pay is by looking at the order in which you take your pension and other savings.
In fact, prioritising which savings you use up first can be almost as important as saving itself, and can also help you to leave more money to your loved ones as an inheritance.
Here, Telegraph Money outlines nine ways to reduce tax on your retirement savings, and help them to last longer.
Remember that just because you’ve reached retirement, you don’t have to access your pension funds unless you need to – in fact, it’s best to leave your money alone for as long as possible. Pensions, Lifetime Isas and other Isas will continue to grow tax-free when you’ve reached retirement, so you should try to avoid taking money out of these kinds of accounts until you actually need the income.
By taking money out of these accounts, you forfeit the tax-free status of the cash you withdraw. Not only this, but you reduce your annual pension contribution allowance due to triggering the “money purchase annual allowance” (MPAA).
If you take income from a “flexi-access” drawdown account while you’re still working and saving into the account, this will severely limit the amount you can continue to save tax efficiently in the future.
This is because you are able to save up to £60,000 per year tax-free into your pension before you start withdrawing. However, if you do start to take from your pot, this amount drops to £10,000. This is known as the “money purchase annual allowance” (MPAA).
If you’re concerned about your pension’s investment performance, or uncomfortable with the level of risk as you get closer to needing to make withdrawals, don’t be tempted to withdraw cash to save into a bank account or cash Isa.
Instead, consider moving your pension into lower risk funds to avoid large market fluctuations. If you have already signed up to it, many pension funds will do this automatically to protect you when you’re close to retirement – this is called “lifestyling”.
Check with your provider for more information on your fund and whether you’ve chosen this strategy. It may be that your pension has been “lifestyled” out of stock market investment and into bonds and cash – which may be the wrong mix of assets if you want to remain invested for a decade or more beyond retirement.
When you do decide to start withdrawing from your pension, it is most tax-efficient to phase your pension income by taking the 25pc tax-free lump sum and taxable income in stages. This helps make the most of tax allowances and avoids incurring unnecessary income tax by falling into a higher bracket.
Isas can also be used to provide a retirement income, which won’t affect your tax-free pension contributions if you’re continuing to save.
Withdrawals are tax-free, but they can come with other penalties depending on the type of Isa you have, so be sure to check the terms and conditions first.
Lifetime Isas, on the other hand, only offer penalty-free withdrawals once you’re over the age of 60 – before this, you’ll lose 25pc on the amount being withdrawn, unless you’re using the money to buy your first home.
If you are able to draw a regular income from Isa savings, doing this can be a helpful way to top up your income when moving from full-time work to reduced hours, to full retirement.
Using this money first means you can keep paying up to £60,000 into your pension tax-free, and is prudent from an inheritance tax perspective as Isas form part of your estate.
There are, however, special tax rules between spouses and civil partners who can inherit their partner’s Isa allowance.
You can usually take up to 25pc of your pension fund tax-free, from age 55 (due to rise to 57 in 2028), and doing this won’t affect the amount of tax you pay.
You have to purchase an annuity or go into drawdown at the same time as taking your tax-free cash sum.
Taking a 25pc cash sum will not trigger the MPAA, as long as you don’t take any extra withdrawals from your drawdown account.
When you come to draw your pension, some people buy an annuity. These insurance contracts provide a guaranteed annual income for life, or a set amount of years, and is subject to income tax.
A more popular option is “pension drawdown”, which is where you keep your money invested and make regular or ad-hoc withdrawals whenever you like. The major benefit is you can keep investing the remainder of your fund, which means it can still increase in value and keep pace with inflation (or hopefully exceed it). Money in drawdown is also free of inheritance tax.
The money you withdraw is still subject to income tax, but since you’re in charge of how much you draw out, you’re also essentially in charge of how much tax you pay. This means if you only take up to £12,570 a year (and don’t have any other income sources) you can avoid tax entirely.
Alternatively, if you’re already close to the next tax bracket you can decide not to draw it so you avoid paying the higher rate of tax, 40pc or 45pc, on your drawdown amount.
Dean Butler, of Standard Life, said: “Accessing your pension via drawdown lets you take money out of your pot when you need whilst the remainder stays invested, meaning it has the potential to grow. It’s also possible to mix and match by using a portion of your pension to buy an annuity to cover essential outgoings and then accessing the remaining pot to draw down an income as required for additional spending.”
One of the most difficult financial decisions we make is mapping out an effective pension strategy. Deciding whether to purchase an annuity or opt for pension drawdown is a particularly complex element of this. That’s why we’ve created an in-depth guide comparing pension drawdown vs annuities to help you employ a retirement strategy that works for you.
If your income is less than the personal tax allowance (£12,570) you won’t pay any income tax. Any pension income, including the state pension, is taxable, so you’ll pay income tax on anything above this figure.
If you have a spouse or civil partner who is a basic-rate taxpayer, using the marriage allowance means you can essentially transfer 10pc of your personal tax allowance to your partner. This can save £252 a year. However, because your personal allowance is lowered, if you earn more than £11,310 you could be caught by basic-rate tax.
In order to lower your taxable income further, it’s worth looking into any salary sacrifice schemes offered at your place of work, enabling you to redirect a portion of your salary into pension contributions. This effectively lowers your taxable income, benefiting from income tax relief and making the most of your personal allowance.
You can cash in up to three small pension pots – that is, those containing savings of less than £10,000 – from “personal pension” schemes without triggering the MPAA.
Note that if the small pot payment is paid from “uncrystallised” funds, 25pc will be paid tax-free and the remainder will be taxed as income. If it’s paid from “crystallised” funds, the full amount is taxable.
You should generally access your pension savings last – that is, after using your Isa savings and pension tax-free cash. This is because pension income is taxable under the income tax rules (although, as noted above, income up to £12,570 is tax-free).
Delaying taking your pension income will help it to last longer, and allow you to continue making higher tax-free contributions if you are still working.
However, upcoming reforms have changed the general advice on tax planning.
From April 2027 unspent pensions will no longer be exempt from death duties. This is already the case for Isas and savings accounts.
It means there could be a sizeable inheritance tax bill to pay. For those with large estates (especially if you don’t have a partner or your partner has already died) it may no longer makes sense to leave large sums in pensions in later life. See more on this below.
Pension income, including the state pension, is taxable. It’s therefore important to consider all forms of income you receive – including state pension payments, rental and dividend income – when using drawdown in case this pushes you into a higher tax bracket.
Only take out as much money as you need to fund the lifestyle you want, and that your retirement savings can afford.
The income tax rates and thresholds for England, Northern Ireland and Wales are detailed in the table below:
Pension savings, unlike money held in Isas, generally don’t form part of your estate when you die, so inheritance tax isn’t normally payable. This is another reason to prioritise spending money held in other accounts before turning to your pension.
If you die before your 75th birthday, your unused pension funds can be paid tax-free to your loved ones either as a lump sum or as income, if paid within two years. If you die after age 75, any unused pension fund is taxed at your loved one’s income tax rate.
This can be significantly cheaper if they are a basic-rate taxpayer as they’ll be charged 20pc versus the 40pc inheritance tax charge. But, if they’re an additional-rate taxpayer, they’ll be taxed at 45pc.
However, it was announced by Chancellor Rachel Reeves in last year’s Autumn Budget that unused pension savings will be included in your estate from April 2027. Therefore, depending on the amount you leave to your loved ones, they may incur inheritance tax of 40pc if they exceed the £325,000 “nil-rate” allowance.
With these inheritance tax developments in mind, regularly gifting to loved ones from any surplus income, whether that be through work or through your pension, will reduce the value of your estate and ultimately lower the inheritance tax burden on your beneficiaries.
For more information, you can visit our in-depth guide on gifting out of surplus income.
You might be owed a tax refund if you’re taxed at an “emergency” rate when you make a withdrawal.
When you come to draw your pension, you can take up to 25pc as a tax-free lump sum. However, if your provider doesn’t know your tax code, you might be taxed at an “emergency” rate. This is particularly frustrating if you had specific plans for the money or needed it quickly.
You are entitled to get this back. Over time, HMRC should even out your tax code and return it to you. However, applying for a refund is usually a lot faster.
To avoid this happening you can either provide a P45 to your pension provider or ask HMRC to send them a new tax code. Do this before you draw your lump sum.
You pay tax on your pension in the normal way when you draw it. If your total earnings are between £12,570 and £50,270, you’ll pay 20pc. Anything between £50,271 and £125,140 means 40pc tax is charged, with the rate climbing to 45pc for anything over that.
Everything you earn counts, including the state pension. Your lump sum, up to 25pc of your pot, is usually tax free.
Previously, there was an additional tax charge for drawing a pension over the “lifetime allowance” of £1,073,100. This was removed from April 6, 2023, but the maximum tax free lump sum amount has been frozen at £268,275.
Pensions are taxed because they are classed as income. However, when you build up your pension, you are given tax relief as an incentive to save. So for every £100 in it, it only costs you £80 (or £60 if you’re a higher rate tax payer).
There can be a very expensive tax applied if you take your pension before the age of 55, which can cost you up to 55pc in tax. This is generally not advised and some pension funds won’t even let you do it. Exemptions do exist, but typically only in two cases:
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You are forced to retire due to ill health.
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You are terminally ill with less than a year to live.
When your pension provider doesn’t have the correct tax code for you, an emergency tax code is applied on a month one (M1) basis. This is calculated as if the payment is at a regular monthly income without taking into consideration other earnings in the tax year.
Usually, this leads to people overpaying on tax in their first month, although, in some cases, the opposite may be true. You will need to either claim a refund or end up paying more tax at a later stage if you’ve underpaid.
To try and avoid this, ensure your provider has the right tax code for you before your first withdrawal by providing them with a P45. If you don’t have access to one, contact HMRC for a new tax code and relay this back to your provider.
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