The transition to retirement is a significant moment in your life. After years of hard work and saving, you can enjoy spending time with family, pursuing new hobbies, or travelling the world.
However, you may find it more difficult to achieve your desired lifestyle if high taxes significantly diminish your income in retirement.
Unfortunately, new data reported by IFA Magazine reveals that this could be more likely in the future as 1 in 5 pensioners are expected to pay higher- or additional-rate tax by 2028.
Read on to learn why this is and how you could potentially reduce your bill.
3.1 million pensioners could be dragged into paying higher- or additional-rate Income Tax by 2028
One of the key reasons why you may be more likely to pay tax in retirement is that certain tax thresholds remain frozen while your income could rise over time.
Your Personal Allowance is the amount of income you can generate before paying tax. This includes earnings from work, as well as wealth you draw from your pensions.
In his 2022 Spring Statement, then-chancellor Rishi Sunak announced that the Personal Allowance would be frozen at £12,570 until 2026. Jeremy Hunt later extended the freeze until 2028.
As such, in 2024/25, any income that exceeds your Personal Allowance of £12,570 will be taxed at your marginal rate of Income Tax. Unless the government changes the policy, this will continue to be the case until at least April 2028.
Meanwhile, the State Pension typically increases every year because of the triple lock guarantee. The State Pension payment you receive rises every April by the higher of:
- The rate of inflation
- Average wage growth
- 2.5%.
According to TFP Calculators, in 2021/2022, the full new State Pension payment was £9,339.20 a year. Since then, the amount has increased annually and in 2024/25, it is £11,502.40. This wealth counts towards your taxable income.
As such, if you claim the full new State Pension in 2024/25, you have already used a significant portion of your Personal Allowance for the year.
According to the Guardian, it is predicted that the full new State Pension payment could increase by as much as £460 in April 2025. This could mean that you’re even more likely to exceed your Personal Allowance in the future.
Additionally, inflation means that living costs have risen considerably in recent years. For example, the Food Foundation reports that, in the two years to April 2024, the cost of an average basket of food from Tesco has increased by 26.2% for men and 23.8% for women. You have likely seen an increase in your energy costs too.
Consequently, you may have to draw a higher income from your pensions to maintain your lifestyle in the future. In some cases, you might move into a higher tax bracket as a result.
This combination of State Pension increases, and inflation meaning you need to draw more wealth from personal pensions to afford your lifestyle, could mean that your income rises over time. Meanwhile the Personal Allowance remains the same. As a result, more of your income could exceed the threshold, meaning you pay more tax.
This situation – known as “fiscal drag” – is the reason IFA Magazine reports that 3.1 million pensioners could be dragged into paying higher- or additional-rate tax by 2028.
Fortunately, there are three ways to potentially reduce your bill.
3 ways to reduce your Income Tax bill in retirement
1. Be strategic with your tax-free lump sum
In 2024/25, you can normally withdraw the first 25% of your defined contribution (DC) pension as a tax-free commencement lump. You will then pay tax on withdrawals you make from the remaining 75% of your pension pot if they exceed your Personal Allowance.
Many pension providers allow you to take your tax-free lump sum in several instalments, and you may be able to draw from the taxable portion of your pensions at the same time. This could help you reduce the tax you pay.
For example, if you drew £1,000 a month from the tax-free portion of your pension and another £1,000 from the remaining taxable portion, you would have a monthly income of £2,000 (or £24,000 a year).
Yet only £12,000 comes from the taxable portion of your pension, meaning you are still within your Personal Allowance and won’t pay Income Tax (assuming you have no other income).
Using your lump sum strategically in this way could mean that you’re able to reduce the tax you pay in the future.
Bear in mind that you can only benefit from this strategy until your tax-free lump sum runs out, but it may still be a useful way to mitigate tax in the early years of your retirement.
The size of your tax-free lump sum is also limited by the Lump Sum Allowance (LSA), which stands at £268,275 in 2024/25. You could pay tax on any withdrawals that exceed the LSA. However, your LSA may be higher if you previously applied for Lifetime Allowance (LTA) protection or had scheme-specific tax-free cash protection.
It may be worth seeking professional advice if you are unsure how much tax-free cash you can take from your pensions.
2. Only draw what you need from your pensions
Once you have used your tax-free lump sum and continue to draw from your pensions, any income that exceeds your Personal Allowance will be subject to Income Tax.
It’s important to consider how much you draw from your pensions so you can potentially reduce the tax you pay and avoid moving into a higher tax bracket, where possible.
For example, if you took £50,000 from your pensions, you would pay £7,486 in tax (assuming you’ve already used your tax-free lump sum).
However, if your annual expenses are only £45,000 a year, you’re unnecessarily paying tax on £5,000 of your savings.
Conversely, if you left those funds in your pension and only drew the £45,000 you needed, you would pay £6,486 in tax – a saving of £1,000.
The additional £5,000 also remains invested, so you may see some growth on it too.
That’s why you may want to create a detailed retirement budget as it gives you a clear idea of what level of income you need to pay for your desired lifestyle. In some cases, you might find that you don’t require as much as you first thought.
Ultimately, this means you can take only what you need and potentially reduce your tax bill while leaving the rest of your savings invested.
3. Use savings from other tax-efficient sources
You may also be able to reduce your taxable income by drawing your income from other more tax-efficient sources, such as ISAs.
This is because you don’t pay Income Tax, Capital Gains Tax (CGT) or Dividend Tax on interest or growth from wealth in an ISA. You won’t pay tax when drawing funds from an ISA either. So, if you can rely on these savings before accessing your pensions, you could reduce the tax you pay.
Additionally, you could combine pension income with ISA savings to mitigate a large tax bill.
Using the previous example, if your annual expenses are £45,000 and you draw the full amount from your pension, you will pay £6,486 in tax, assuming you’ve already used your tax-free lump sum.
Conversely, if you took £25,000 from your pension and another £20,000 from your ISAs, the wealth from your ISA would be tax-free. This means you would only pay £2,486 in Income Tax on your pension income.
Alternatively, if you drew £10,000 from your pension and £35,000 from your ISA, you wouldn’t exceed the Personal Allowance and so wouldn’t pay any Income Tax at all.
We can help you determine the most tax-efficient way to draw from your pensions and other savings.
Get in touch
If you’re concerned about the tax you could pay in retirement, we can support you.
Please contact us at hello@ardentuk.com or call or WhatsApp us on 01904 655 330. As an award-winning financial advice company with advisers included in the 2024 VouchedFor Top Rated guide, you can be sure that we’re a bona fide company providing excellent advice and high-quality service.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
Workplace pensions are regulated by The Pension Regulator.
Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.