5 ways to reduce your tax bill in retirement

The state pension will increase by 4.1% next year 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.

Against this backdrop, an increasing number of pensioners are finding themselves paying a tax bill 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 five 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. “This strategy can be useful in minimising the overall tax burden”, says Henrietta Grimston, director of financial planning at Evelyn Partners.

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.

2. Make the most of your tax-free allowances

If your state and private pension (plus any other taxable income) doesn’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.

Savings interest

Most people can earn a certain amount of interest on their savings without having to pay any tax.

If you are a basic-rate taxpayer, then you are entitled to earn up to £1,000 in tax-free interest. This is called the personal savings allowance. This falls to £500 for higher-rate taxpayers, while additional-rate taxpayers aren’t entitled to anything at all.

On top of this, if your annual income in retirement is less than £17,570, you could be entitled to an additional £5,000 in tax-free savings interest each year – also known as the starting rate for savings.

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.

The starting rate for savings and the personal savings allowance can be added together – so if your annual income is less than £12,570, you could be entitled to earn £6,000 in savings interest without paying any tax at all.

Investment income

If you have any investments sitting outside a pension or ISA, you can earn a certain amount of tax-free investment income. This is known as the dividend allowance.

The dividend allowance has been slashed in recent years – from £2,000 in 2022/23, to £1,000 in 2023/24, to £500 in 2024/25. As such, it is worth moving any taxable investments into an ISA. You get a £20,000 ISA allowance each tax year.

Capital gains

You can also earn a certain amount from capital gains before tax is due, although this allowance has also been cut from £12,300 to £3,000 in recent years. On top of this, Reeves used the Autumn Budget to increase the rate of capital gains tax. Against this backdrop, your ISA allowance is more important than ever.

3. If you come out of retirement, continue paying into your pension

Research published by Standard Life earlier this year revealed that 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.

“You can still pay into your pension even if you’ve already accessed it”, explains Charlene Young, pensions and savings expert at AJ Bell. However, it is likely that you will have a lower limit on what you are allowed to put in. The annual allowance for people who have already accessed their pension (known as the Money Purchase Annual Allowance) is usually £10,000 a year.

This is considerably lower than the annual allowance for those who haven’t retired yet, currently set at £60,000. So it is worth planning your finances carefully to try to avoid coming out of retirement, if you can.

4. When saving for retirement, consider supplementing your pension with an ISA

Each year, most people are entitled to stash up to £60,000 in their pension pot tax-free. This includes contributions from yourself, your employer and HMRC in the form of tax relief. But if you are a high earner and have some spare cash to put aside once you have maximised this allowance, you might want to consider putting the money in an ISA.

An ISA could also be a good option if you need greater flexibility. Savers cannot access the funds in their private pension until they are 55, but you can access an ISA at any time (provided it is an easy-access account).

The drawback of an ISA compared to a pension is that you won’t receive any tax relief on contributions. As such, it is worth maximising your pension contributions first, unless you think you might need the money before you reach retirement age.

5. Once you have maximised your pension and ISA, consider other investments

If you are still saving for retirement, and you have already maximised your pension and ISA contributions, it could be worth looking at some other tax-efficient options. Premium Bonds are a good option for some savers, as the cash prizes you can win are tax-free. The product currently offers an average return of 4.4% – although this will fall to 4.15% from December’s draw.

You can hold up to £50,000 in Premium Bonds, and they are incredibly safe as they are backed by the government. However, it is worth remembering that you could earn a higher return than this in the stock market over the long term. What’s more, the top cash accounts are currently paying around 5%. As such, it is worth exhausting your ISA allowance before turning to Premium Bonds.

Sophisticated investors can also look into tax-efficient investments like venture capital trusts and offshore investment bonds, but these are far more complex investments, so you will need to know what you are doing. Before moving ahead, it could be a good idea to sit down with a financial adviser.