How to avoid paying tax on your pension

Pensions, like most forms of income, incur taxes. However, there are ways to ensure you’re not unnecessarily overpaying in tax, even when you’ve retired.

Will I be required to pay tax on my pension?

The short answer to the question “do you pay tax on your pension?” is yes, so long as your pension exceeds the minimum threshold for paying income tax.

Income from a pension is taxed exactly like any other form of non-savings income. Firstly, everyone has a personal allowance, which is the amount of money you’re allowed to earn each year before you start paying income tax. Currently, the personal allowance is £12,570 (though this may be reduced if you have earnings above a certain level), so if you receive less than £12,570 per annum of taxable income, then you pay no income tax. Once your taxable income goes above this level you become liable to pay 20% income tax on taxable income between £12,571 and £50,270 per annum. This then increases to 40% income tax for taxable income between £50,271 and £150,000, and 45%  beyond that. These income tax rates are valid as of 2022 and have been frozen until 2026 following an announcement in the 2021 Budget but are likely to alter in subsequent years. For updated and current tax rates, see our latest tax tables. However, under certain circumstances, you do not need to pay tax on all of your pension income. Additionally, there are strategies you can adopt to minimise the amount of tax you pay on your pension.

How much will I be taxed on my pension?

Another frequently asked question is “how much tax do you pay on your pension?”. As stated above, the amount of income tax you pay on your pension depends how much you take out.

The good news, is that some of your pension is, in fact, tax free. If you have a defined contribution pension, whereby your pension is based on how much you and/or your employer have saved into it — which is the most common kind — then you can take out 25% of your pension completely tax-free. Typically, this is achieved by taking a quarter of the pension pot in a single lump sum withdrawal. However, it is possible to take out multiple smaller lump sums each with 25% tax-free, or just take portions of tax free cash over time rather than all at once. The remaining 75% will be taxed according to the standard rules explained above.

If you are only receiving the new state pension, on the other hand, then you do not need to worry about income tax. With effect from the 11th April 2022, the full new state pension is £185.15 per week, or £9,627.80 per year — since this amount is within your personal allowance there will be no income tax to pay. Most people who have worked throughout their lifetime will be eligible for a state pension, although the amount you receive will depend on your national insurance record.

However, if you have income from other sources bringing your yearly income higher than £12,570, then you may be expected to pay income tax.

What other forms of tax for my pension should I be aware of?

Income tax is the main tax you can expect to pay on your pension. However, if your pension pot has grown to be a large sum and exceeds the lifetime allowance, then you will be liable to pay an additional tax charge.

The lifetime allowance is currently £1,073,100. Which may seem like a lot of money, but for those with employee and employer contributions, over time and especially with some older ‘gold plated’ final salary schemes, even those of relatively modest incomes could breach the lifetime allowance. If your combined pension pots exceed this amount, then you will be subject to an extra charge. The amount charged will depend on whether you withdraw your pension in a lump sum or drawdown on it as an income. As a lump sum, it will be taxed at 55%, as an income it will be around 25% on top of the individual’s marginal rate of income tax.

If you think your pension pot exceeds the lifetime allowance cap, you may be able to apply for pension lifetime allowance protection and therefore you may also be eligible for a higher lifetime allowance. Find out more about the pension lifetime allowance protection in our article. 

How to avoid paying tax on your pension

If you want to mitigate tax on your pension, the only certain way to do it is to ensure that your total taxable non-savings income, including your pension income, is below the personal allowance. However, this will likely not permit you your desired standard of living in your retirement years.

Instead, there are a few tips and tricks for limiting the amount of tax you are liable to pay on your pension. These are outlined below:

Only withdraw the amount you need each tax year

Of course, you should take out as much as you need to live a comfortable life, but you might want to keep an eye on staying within certain tax thresholds. For example, if you are careful to take out no more than £50,270 in the current tax year, including any other income sources, you will only need to pay 20% income tax. However, if you were to take out £50,271 or more, you’d pay 40% on the amount over £50,270, up to the next tax threshold. 

Note that at retirement stage, you aren't required to draw down on your pension income to put into savings. This means it can be more financially beneficial to withdraw less, or none, and stay within a low tax range, rather than withdraw more an have to pay substantially more tax.

Take advantage of a drawdown scheme

Drawdown allows you to vary your income from year to year, meaning you can opt to keep it below a certain tax range in a given year. This is not possible for you, however, if you have an annuity, since annuity income cannot be varied at will. Bear in mind that drawdown does come with some risks, so always check with a financial advisor before you pursue it as an option.

Take out your pension pot in one lump sum

As mentioned, 25% of your pension pot is tax-free when taken out as a single lump sum. However, be aware that the other 75% will count as income and will be taxed accordingly, so taking the remainder in a lump sum as well may only be a smart option for small pension pots — where the addition of the taxable 75% won’t push you into the next tax band.

Don’t draw your pension in one go

As is evident from the points above, staggering your pension so that you receive less on an annual basis ultimately means you will pay less tax. While you might be tempted to empty your pension pots in one go, it will mean paying income tax on that amount in one year. In most cases, this would be a poor decision from a tax perspective as it may result in your income falling into the higher tax rate bands and triggering a significantly larger tax bill.

The importance of Pension Freedoms

With the introduction of Pension Freedoms in 2015, this allows far more flexibility for an individual when they come to draw their pensions.  An individual can now draw their pension from minimum pension age onwards, when and if they like, in any portion that they like. As well as this flexibility allowing an individual to tailor their income needs around their chosen lifestyle, it also allows far more flexibility with regards to tax planning, including income tax, lifetime allowance tax, as well as inheritance tax which are all intertwined when planning in this nature. It is therefore important that your pension schemes have adopted the Pension Freedoms, to ensure that you have absolute flexibility both on drawing an income as well as on death. It is important to note that not all pension schemes have adopted modern flexibilities. If you are unsure, get in touch.

So, the only way to truly avoid paying tax on your pension is to ensure your pension withdrawals (including your state pensions) do not exceed £12,570 per year.

Ways to reduce tax on your pension however include:

  • Not withdrawing more than you need from your pension each year.
  • Utilising a drawdown scheme so that you can vary your yearly pension income.
  • Taking out small pension pots in one lump sum to benefit from 25% being tax free.
  • Avoid drawing large pensions in one go.
  • Phasing tax free cash.

How can we help?

The Private Office offers expert advice on how best to manage your pension, including how to avoid paying unnecessary extra tax. Get in touch to arrange a free consultation.

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Please note: A pension is a long term investment, the value of investments can fall as well as rise. You may not get back what you invest. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.