At a glance
- Today, you’ve got far more flexibility in how you plan your retirement income, but there are a few tax-traps to look out for.
- Paying tax when you’re working is quite different to paying tax when you’re retired, so take advice before you make any sudden changes or costly choices.
- A financial adviser can point you in the right direction and make sure you take your retirement income tax-efficiently.
Once you retire, you pretty much stop paying into your pension and started drawing it. However, many people keep contributing, or keep their pension invested for most of their retirement.
Understanding how your tax position changes when you stop working is an important practical step to staying financially healthy and secure when you retire.
Taking your retirement income tax-efficiently
Planning your retirement income can seem daunting, especially if you’ve managed to save or invest in a range of different assets over the decades. For most of us though, the first thing to consider – your baseline – will be your pension.
The good news is that generally the first 25% that you draw from a Defined Contribution pension is tax-free.
But after that you’ll be taxed at your marginal rate of income tax. So, what other options do you have to fund the retirement you’ve been planning?
If you have money saved in ISAs, you won’t pay income tax or capital gains tax on any amount you withdraw. So you could use those savings and drain that pot first. If you’ll be eligible for a State Pension too, you might not even need to touch your workplace or private pensions.
Those tax advantages are a very good reason to spread your assets. You could diversify into ISAs, cash holdings or even property, while you’re still working. Lots of people rely heavily on a pension income and get hit with a tax bill just because they didn’t know they had other options or income streams.
When you do start drawing your pension, your tax situation alters significantly. While you’ll find plenty of opportunity to be tax-efficient, there are also a few pitfalls that you need to know.
Will I pay tax on my pensions?
The short answer is yes, you will pay tax on your pensions – State, Defined Contribution or Defined Benefit – if they add up to more than your Personal allowance of £12,570 for the 2024/25 tax year.
If you have a Defined Benefit pension (DB), income tax will be deducted at source by your pension provider. If you have a Defined Contribution pension, you can take money out from age 55 (this will rise to 57 in 2028). The first 25% is generally tax free. After that, withdrawals will be taxed at your marginal rate. Your tax rate will increase if your total income goes over the income tax thresholds of £50,270 (higher rate) or £125,140 (additional rate.). You will also lose your personal allowance on a tapered basis if your income exceeds £100,000, reducing it to zero at £125,140.
If you withdraw a larger sum (beyond your 25% tax free cash) from your pension one year, you could take a big tax hit.
Will I always pay tax on my pension, no matter what type I’ve got?
If your annual pension income, plus any other income you receive from savings, or part time work, is less that your £12,570 Personal Allowance, you will not pay income tax.
What if I’ve got different types of pension?
If you know that you’re going to have a combination of Defined Contribution pension (DC) and a Defined Benefit (DB) pension, proper financial advice really is key. That’s because DB pensions generally pay out from a fixed date, assigned by your pension scheme. Although in some cases it is possible to defer this income, taking advice to determine if this is the right thing to do in the long run will mean you don’t miss out. When the income does start, it’s important to know what steps you can take to avoid paying too much tax from the moment you retire.
Will I pay tax on any other retirement income?
By the time we retire, lots of us have a mix of savings, investments, and assets. You could well have pension, Cash ISAs, Stocks and Shares ISAs, property, even part-time earnings. It’s up to you to choose how and when you draw money from these – you’re in control and can work this to your advantage. But some of those income sources are treated and taxed differently.
If you have income from more than one source, you’ll need to declare this clearly on your tax return – so you pay the right amount of tax against each income. Your Personal Allowance will normally be applied to your pension or job if you’re still working. But your savings will be counted against your Savings Allowance. That’s £1,000 for basic rate taxpayers, £500 for higher rate taxpayers and no allowance at all for additional rate taxpayers.
There are some no-catch tax breaks when you stop working though. You won’t have to pay National Insurance contributions after hitting State Pension age.
Look out – Emergency Tax hazard ahead
Since the 2015 pension reforms, generally Emergency Tax is applied to initial payments from pension schemes, if you are taking a large taxable amount then this could mean that you will pay a significant amount too much tax. Emergency Tax is temporary – until HMRC works out what tax code you should be on.
If you are taking a regular income from the scheme then it will generally work itself out throughout the year and you will get it back without needing to do anything. If you are taking a one off payment then you can reclaim this directly from HM Revenue and Customs, it isn’t difficult to do, although finding the correct form can be more of a challenge.
Similarly, taking a lump sum, or a higher income from a pension pot could push you up into a higher tax band, particularly if you’re a basic-rate taxpayer hovering below the higher-rate threshold. Anything taken out above the tax free amount is taxed as income however it is drawn.
However, if you can stagger withdrawals over two tax-years, you might be able to stay just under the basic rate threshold.
How can I avoid paying too much tax when I retire?
Nobody wants to pay more tax than they need to, especially in retirement. But taxation in retirement can be very different to taxation when you’re still working. It’s easy to miss some of the pitfalls, especially if your employer used to work out all the ins and outs of taxes.
Tax regulations are complex, and the goalposts are always moving, so you need somebody who can flag any that might apply to your situation.
Financial advice and a tax-smart retirement
A financial adviser can help you make a tax-efficient plan for retirement income. They’re across any changes to the regulations, and they’ll help you plan. Then, you can get on with enjoying the retirement you’ve imagined – and worked for.
Need some help with creating a tax-efficient plan for your retirement? We can help.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time and are generally dependent on individual circumstances.
You can also access free impartial pensions guidance from the Pension Wise website or you can book an appointment over the telephone 0800 011397.
SJP Approved 15/02/2024