Five steps to reduce your tax bill in retirement

The state pension has increased by 8.5%. But with income tax thresholds still frozen, you could see your tax bill go up too. Here's how to reduce your tax bill.

Reduce your tax bill: a retired couple sitting on roll of UK bank notes.
(Image credit: Getty Images - Peter Dazeley)

Inflation and the cost-of-living crisis are causing concern among pensioners and those saving for their golden years.

The cost of a comfortable retirement has soared, and some are even being forced to “unretire” in an attempt to top up their pension pot.

The good news is that state pension payments have increased by 8.5% as of 8 April, in line with triple lock rules. But every rose has its thorn – and in this case, the thorn in question is a higher tax bill.

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Income tax thresholds remain frozen, which means that many pensioners will now be pushed into a higher rate of tax. 

The number of pensioners paying income tax is already at around 8.5 million, according to AJ Bell. Fiscal drag and the increase to the state pension will compound this further going forward. 

New research from the House of Commons Library reveals that an additional 1.6 million pensioners are set to pay income tax by 2027/2028. With this in mind, 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, you can simply withdraw the tax-free cash as and when you need it.

2. Make the most of your tax-free allowances

If your state and private pension payments (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.

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 tax-payers 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 earn up 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 of a pension or ISA, you can earn a certain amount of investment income tax-free. This is known as the dividend allowance. It was set at £1,000 for the 2023/2024 tax year, but has been cut to £500 as of 6 April this year.

As such, it is worth moving any taxable investments into an ISA. You get a £20,000 ISA allowance each tax year.

Capital gains

Again, if you have any investments sitting outside of your pension or ISA, you can earn a certain amount in capital gains before any tax is due. Capital gains tax is paid when you sell the investments.

The capital gains allowance was £6,000 for the 2023/2024 tax year, but this has also been slashed to £3,000 as of 6 April this year. This is another reason why it is worth moving these investments into an ISA.

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

Research from Standard Life 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. 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 actually be worth continuing to contribute to your pension. Doing this could lower the amount of income tax you pay, as you will benefit from pension tax relief – not to mention 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

If you are still working and saving for retirement at a date in the future, there are some pre-emptive steps you can take today to reduce your tax bill further down the line.

Each year, most people are entitled to stash up to £60,000 into their pension pot tax-free. That includes contributions from yourself, your employer and HMRC in the form of tax relief. If you are a high earner and have some spare cash to put aside once you have maximised this allowance, then 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 pension until they are 55 (this is set to rise to 57 in 2028). Meanwhile, 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 from HMRC – the money you pay into an ISA has already been taxed when you earned it.

You won’t be taxed when you draw any money from an ISA, but the tax benefits on pensions are more generous than those on ISAs overall. As such, it is worth maximising your pension contributions first, unless you think you might need the money before you reach retirement age.

Commenting on the perks of pensions in general, Grimston explains that “[f]or many pension savers, the tax benefits of reliefs at the contribution stage outweigh the tax paid at access, even if withdrawals are taxed”. This logic can also be applied when looking at the argument for pensions versus ISAs.

She adds: “This is most obviously and commonly the case where a saver received tax relief on their pension contributions at the higher or additional rate, but then pays tax at a lower rate when they come to draw a pension income.”

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, and the product currently offers an average return of 4.4%. “That is a very handy tax-free return”, explains Grimston, “but an individual holder might do worse or better with their annual prize haul”. This is because there are no guarantees that your bonds will be selected in the 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 significantly higher return than this in the stock market – and even cash accounts are currently offering interest rates north of 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 advisor.

Katie Williams
Staff Writer

Katie has a background in investment writing and is interested in everything to do with personal finance and financial news. 

Before joining MoneyWeek, she worked as a content writer at Invesco, a global asset management firm, which she joined as a graduate in 2019. While there, she enjoyed translating complex topics into “easy to understand” stories. 

She studied English at the University of Cambridge and loves reading, writing and going to the theatre.