Did you know that you could potentially reduce the tax on your pension?

As you approach retirement and you consider drawing from your pension, you may need to think about the Income Tax you are likely to pay.

According to FTAdviser, in 2023/2024, 8.5 million people over the age of 65 will pay Income Tax. This is an increase of around 10% on the previous year and is likely a result of inflation and frozen Income Tax thresholds.

While the spring Budget announcement did not include an increase in the rate of Income Tax, that does not necessarily mean that you won’t pay more tax in the future. That’s because the government extended the freeze on Income Tax thresholds until 2027/2028.

As a result, if your income increases while the thresholds stay the same, more of your earnings may be pulled into the taxable range, thereby increasing your Income Tax bill. 

This is known as “fiscal drag” and it is becoming more likely as inflation remains high and earnings increase. 

It may also affect retirees drawing income from a pension because you may have to take a larger income to account for increased living costs. Additionally, your State Pension will likely increase in line with inflation.

Consequently, you could lose a significant amount of your pension savings to Income Tax. It is important to consider this when drawing your pension, so you can retain as much of your wealth as possible and maintain your lifestyle.

Fortunately, there are several ways to potentially reduce the tax you pay on your pension.

How to potentially reduce the tax on your pension  

1. Check the tax on your first withdrawal

Checking that you have paid the correct amount of Income Tax on the money you draw from your pension is crucial as you may be charged too much. 

Indeed, MoneyAge reports that HMRC repaid £134 million in overpaid tax on pensions in 2022.

This is particularly common when you first draw from your pension because you may be put on a “month one” tax code – this emergency tax code means that you could pay more tax than you need to.

Fortunately, you can claim a rebate, but you may need to check whether you have paid the correct amount of tax first, and claim it back if you have overpaid.

2. Consider how you draw from your pension

The way that you draw money from your pension often has a significant effect on the tax you are likely to pay on it.

You are typically able to draw 25% of your pension as a tax-free lump sum. Normally, your pension provider will allow you to take it in one go or in smaller amounts and you may want to consider which option is the most tax-efficient for you.

Unfortunately, many people make the mistake of drawing their entire pension fund as a single lump sum. In this instance, 25% of the fund is tax-free but the rest is considered income and taxed accordingly.

If this pushes you into the higher- or additional-rate tax bracket, you could potentially lose 40% or 45% of your entire pension fund to Income Tax.

That is why you may need to consider how you draw from your pension, and do not draw more than you need to. 

If you can spread it out and draw less than £50,270 – the threshold for higher-rate tax – and supplement your income from other sources, such as savings in an ISA, you would only pay basic-rate Income Tax, for example.

If you’re married or in a civil partnership, drawing income carefully between you can also ensure you minimise the tax you pay. For example, equalising your income so you both pay basic-rate Income Tax might result in an overall lower tax bill than if one of you were a higher-rate taxpayer and one paid no Income Tax at all.

It is equally important to consider this when drawing flexibly from your pension in the future. It may be useful to think about how much you realistically need to fund your lifestyle, and try to avoid taking more than this. 

By limiting the amount that you draw from your pension, you may be able to reduce Income Tax and you also leave more of your wealth in your pension, where it has the potential to grow. This could mean you have a larger pension pot to spend in the future and you are able to fund your lifestyle for longer.

3. Spend your other savings first

If you have other savings, in an ISA or a cash savings account, for example, it may be beneficial to draw your income from these first for several reasons.

As already discussed, this could reduce the amount of taxable income you need to draw from your pension, meaning that you don’t lose as much to Income Tax. 

Further to this, funds in an ISA will likely form part of your estate for Inheritance Tax (IHT) purposes, while your pension will not.

If you can retain wealth in your pension for longer, you will be able to pass this on and your family will not have to pay any IHT on it.

Remember that your pension may not be covered by your will, so it is important to nominate the beneficiaries of your pension now. You can normally do this by contacting your pension provider to fill out an “expression of wishes” form.

Get in touch

If you are concerned about the tax you may pay on your pension, we can potentially help you find ways to be more tax-efficient.

Please contact us at hello@ardentuk.com or call 01904 655 330. As an award-winning financial advice company that was a 2022 VouchedFor Top-Rated firm, you can be sure that we’re a bona fide company providing excellent advice and high-quality service.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

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 results. 

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.

This article is for information 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.

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