The state pension will increase by 4.1% this April in line with triple lock rules, bringing the annual figure to £11,973 for recipients of the full new state pension. This is within touching distance of the tax-free personal allowance of £12,570.
An increasing number of pensioners are finding themselves paying tax in retirement as other sources of income push them over the threshold. This will only be compounded further going forward thanks to the effects of fiscal drag.
Although chancellor Rachel Reeves did not extend the freeze on thresholds in her Autumn Budget, they won’t be reviewed until 2027/28 thanks to decisions made by the previous Conservative government.
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The number of pensioners paying income tax is already at around 8.5 million, according to recent data from HMRC. Research from the House of Commons Library reveals that an additional 1.6 million pensioners are set to pay income tax by 2027/28.
Against this backdrop, we share six tips to reduce your tax bill in retirement.
1. Withdraw the tax-free portion of your pension in instalments
When you first retire, you can access up to 25% of your pension pot tax-free. Lots of people take this as a one-off lump sum, however you can also draw it in a series of instalments.
By leaving the bulk of the sum invested, you can continue to benefit from investment growth. Then, each time you make a withdrawal, 25% of it can be taken tax-free. If your pension pot continues to appreciate, the tax-free portion of it will continue to grow too.
For this reason, withdrawing your tax-free cash in instalments is often more tax-efficient.
2. Beware of emergency tax codes
Many savers will be taxed through an emergency tax code the first time they access the taxable portion of their pension pot. This means they are overcharged and have to apply for a tax refund.
The reason behind this is that HMRC taxes the first flexible withdrawal on a “Month 1” basis. This means the withdrawal is taxed as if it will be the retiree’s income every month for the rest of the tax year.
“You can reclaim the overpaid tax, but it’s easier to reduce this issue by making sure your first withdrawal is a small one,” explains Helen Morrissey, head of retirement analysis at investment platform Hargreaves Lansdown.
3. Make the most of your tax-free allowances
If your state and private pension (plus any other taxable income) don’t already push you over the £12,570 threshold, then you won’t have to pay any income tax. However, even if you do surpass this threshold, there are a range of tax-free allowances that you are entitled to each year. These include:
- Personal savings allowance: Basic-rate taxpayers can earn up to £1,000 in tax-free savings interest each year on balances held outside of an ISA. Anything held within an ISA is tax-free. The personal savings allowance drops to £500 per year for higher-rate taxpayers, before disappearing entirely for additional-rate taxpayers.
- Starting rate for savings: In addition to the personal savings allowance, you could be entitled to earn an additional £5,000 in tax-free savings interest each year, if your annual income in retirement is less than £17,570. Those who earn £12,570 or less are entitled to the full amount. Meanwhile, those who earn between £12,570 and £17,570 will lose £1 of the starting rate for every pound they earn over the personal allowance.
- Investment income: You can earn up to £500 in dividends before tax is due (2024/25 allowance). Again, this applies to dividends earned outside of an ISA wrapper. Anything earned within an ISA is tax-free.
- Capital gains: You can realise up to £3,000 in capital gains (2024/25 allowance) before tax is due. Again, gains realised within an ISA wrapper will be tax-free, regardless of the amount.
It is worth making the most of these allowances to reduce your overall tax burden.
4. Be savvy when it comes to tax thresholds and only withdraw what you need
If your pension withdrawals tip you into a higher tax bracket, it might be worth reducing them slightly to bring you into a lower band. As well as reducing the amount of tax you pay on any earnings that exceed the threshold, this could allow you to hang onto valuable allowances like the personal savings allowance.
Historically, another perk of leaving money invested in your pension – i.e. only withdrawing as much as you actually need to live comfortably on – was that pensions were exempt from inheritance tax. However, these rules are set to change from April 2027, under a policy announced in the Autumn Budget.
The IHT rule-change could impact the way some pensioners manage their retirement savings going forward, as anyone who inherits a pension after this date risks being hit with a double tax bill (inheritance tax and income tax). We share further details in a separate piece: “Pensions face ‘double tax’ due to inheritance tax change – what are your options?”
5. Plan as a couple
Being married or in a civil partnership comes with tax perks. As such, it is worth planning as a couple to reduce your overall tax burden in retirement.
Morrissey points out that, if a couple splits their income needs fairly between them, they can both make use of their £12,570 personal allowance. “You can also share assets between you to make the most of any capital gains tax or dividend tax allowances,” she adds.
6. If you come out of retirement, continue paying into your pension
Research published by Standard Life in 2024 found 14% of retirees over the age of 55 have returned to work as a result of higher living costs and insufficient pension pots.
If this is you, then you might be tempted to use your workplace salary to fund your lifestyle right now rather than continuing to contribute to your pension. Alternatively, you might be tempted to stash it in a savings account or cash ISA for easy access further down the line.
However, it could be worth continuing your pension contributions, as doing this will allow you to benefit from pension tax relief and employer contributions, as well as potentially reducing the amount of income tax you pay.
Charlene Young, pensions and savings expert at AJ Bell, explains: “You can still pay into your pension even if you’ve already accessed it, and it might lower the income tax you pay.
“You’ll likely have a lower limit on what you can pay into your pension each year if you’ve already taken income from a private pension. This annual allowance (known as the Money Purchase Annual Allowance) will usually be £10,000 a year. But provided you don’t go over that and you’re under 75, paying into your pension could move you into a lower tax bracket as it reduces your taxable income.”
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