How to defend your pension from the taxman


No one wants to save up all their working life for a decent retirement only to get stuck with an avoidable tax bill.

Unfortunately, there are many tax traps for the unwary when it comes to pensions. 

It’s especially important to find out about them if you don’t get financial advice when you start tapping your fund.

We asked pension experts for their tips on what trips people up the most often, and how to keep a retirement fund as safe as possible from the taxman.

Retirement planning: How to defend your pension from the taxman

‘How you take your money from your pension is equally as important as building your savings up in the first place,’ says Jenny Holt, managing director for customer savings and investments at Standard Life.

‘If it’s not given the time, effort and energy required the consequences can have a significant impact on your income throughout retirement.

‘For example, the amount of income tax you pay can depend on the way you decide to access your pension, which means you could end up paying more tax than you need to.’

1. Taking a 25% lump sum

When you access your pension savings, you can normally take a quarter of your total pot tax free at the start, says Holt.

However, you can also benefit from this tax perk in slices if your pension plan lets you, getting 25 per cent tax free and paying your marginal income tax rate on the rest of each withdrawal you make over the years.

‘If you have a defined contribution pension, when you take your tax-free entitlement is up to you, provided you are over 55,’ explains Holt.

‘You can take it all at once, but you don’t have to – and it’s important to remember, once it’s gone, it’s gone.’

Holt notes that the longer your money stays untouched inside your pension plan, the more potential it has to grow in a tax-efficient way and the higher your tax-free entitlement could be – though she cautions that’s not guaranteed and pension investments can go down in value as well as up.

Amy Pethers, financial planner at Brewin Dolphin, says: ‘The headline rate of pension tax-free cash is 25 per cent, but some pension savers with older style company pension schemes may find that they have a greater amount of protected cash available.

‘Yet many people in these occupational schemes often forget that they are eligible for this. It is always worth enquiring about your pension’s benefits, rather than assuming they are the same as other schemes.’

2. Annual allowance limits

‘The annual allowance is the maximum amount of pension savings an individual can make each year with the benefit of tax relief,’ says Alice Shaw, financial adviser at Succession Wealth.

‘The annual allowance is £40,000 in the 2022-23 tax year, or 100 per cent of your relevant earnings if you earn less than £40,000, to a minimum of £3,600 gross.

‘For high earners the tapered annual allowance further limits the amount of tax relief high earners can claim on their pension savings by reducing their annual allowance to as low as £4,000.

‘In some circumstances you may be able to take advantage of previous unused allowances for the last three years.’

Shaw warns savers to be mindful of these annual allowance limits, because you are subject to a tax charge on any contribution paid – by you personally, by your employer, or by a third party – in excess of them.

3. Starting to dip into your pot

What are defined contribution and final salary pensions?

Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.

Unless you work in the public sector, they have now mostly replaced more generous gold-plated defined benefit – or final salary – pensions, which provide a guaranteed income after retirement until you die. 

Defined contribution pensions are stingier and savers bear the investment risk, rather than employers. 

When you start tapping a defined contribution pension pot for any amount over and above your 25 per cent tax free lump sum, you are only able to put away £4,000 a year and still automatically qualify for valuable tax relief from then onward.

This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance’.

Holt says: ‘It’s important to understand how taking your pension money could affect the amount you can pay in. 

‘Once you start flexibly accessing any taxable income from your pension savings, the amount that can be paid into any of your pension plans while still getting tax benefits will be limited to £4,000 per tax year.

‘If an employer contributes to your pension, it’s worth calculating if you’d continue to benefit from their full contribution while also drawing a pension income.’

Tom Selby, head of retirement policy at AJ Bell, says: ‘Hundreds of thousands of savers have flexibility accessed their retirement pot each year since the pension freedoms launched in April 2015.

‘And with inflation now ripping its way through the economy, it is likely more over 55s will need to turn to their pension to cover rising living costs.

‘All those who make a taxable withdrawal have their pensions annual allowance savagely cut, from £40,000 to just £4,000 – and there is no going back. Furthermore, they lose the ability to carry forward any unused allowances from the three previous tax years.’

Selby explains that the Treasury introduced this limit to stop people recycling large sums through pensions to benefit from extra tax-free cash.

And he suggests if you want to access your pension but are concerned about triggering the MPAA, you should consider just taking your tax-free cash, particularly if you are planning a one-off purchase rather than taking a regular income at that point.

Selby adds: ‘If you are aged 55 or over and have a small pension pot worth £10,000 or less, it is possible to access this without triggering the MPAA. The whole pot must be withdrawn and it will taxed in the same way as an ad-hoc lump sum withdrawal, with 25 per cent tax-free and the rest subject to income tax.

‘In addition, a small lump sum withdrawal will not be tested against the lifetime allowance (£1,073,100 – see below for more on this), which could be important if you have already used up your allowance or think you might in the future.

‘Up to three pension pots can be treated as small lump sums in your lifetime.’

Jenny Holt: How you take your money from your pension is equally as important as building your savings up in the first place

Jenny Holt: How you take your money from your pension is equally as important as building your savings up in the first place

4. The emergency tax trap

When you reach retirement, it is very important to plan your income carefully in the first year to avoid HMRC levying emergency tax, warns Amy Pethers of Brewin Dolphin.

‘If you take several large sums from your pension over a few months, this may push you into a higher-rate tax bracket and you could temporarily be subject to emergency tax as HMRC may think you plan on doing this for the rest of the tax year.

‘It often makes more sense to spread the cash that you take form your pension over the months and proceeding years so that you have clear plan in place cognisant of the tax that you will be paying.’

Approaching £900million has been repaid to people overtaxed on their withdrawals since pension freedoms were launched in 2015, says Selby.

He explains how emergency tax works, and how to get it back from HMRC, as follows: ‘Your first taxable withdrawal of the tax year will usually be taxed on an emergency basis ‘month one’ basis by HMRC.

‘This means that the Revenue essentially assumes you are making 12 withdrawals rather than just the one.

‘This isn’t a problem if you are taking a regular income as HMRC will adjust your tax code, but if you take a single withdrawal you could end up being overtaxed by thousands of pounds.’

Selby says you can get the money back through your self-assessment tax return, or by filling out one of three forms:

P50Z – if the payment used up your pension pot and you have no other income in the tax year

P53Z – if the payment used up your pension pot and you have other taxable income

P55 – if you have withdrawn only part of your pot and you’re not taking regular payments.

He adds: ‘HMRC says this should get sorted within 30 days. If you don’t fill out one of these forms, you will be relying on HMRC to put you back in the correct position at the end of the tax year.’

Safeguarding your pension: No one wants to save up all their working life for a decent retirement only to get stuck with an avoidable tax bill

Safeguarding your pension: No one wants to save up all their working life for a decent retirement only to get stuck with an avoidable tax bill

5. Your personal allowance and income tax

‘When and how you take your pension can make a big difference to how much tax you pay,’ says Jenny Holt of Standard Life.

‘Taking money little and often can make all the difference so that you don’t pay more tax than you need to.

‘Most people will have a personal income tax allowance that means they don’t have to pay tax on the first £12,570 of their income (for the year 2022/23), such as salary or rental income.

‘Although, if your yearly income is over £100,000, you may not get all this personal allowance, and also your own personal circumstances, including where you live in the UK, will have an impact on the tax you pay and laws and tax rules may change in the future.’

Holt explains that when you make withdrawals from a pension over and above the 25 per cent tax-free lump sum, it’s taxable just like any other income, and so is the state pension when that kicks in.

She says taking little and often from your pension has several benefits. You can stay in the lowest income tax band possible, and retain more of your money overall during retirement, and also keep your money invested with the potential for growth.

Emergency tax: You can claim back your money using the forms linked to above, or wait for HMRC to sort it out at the end of the tax year

Emergency tax: You can claim back your money using the forms linked to above, or wait for HMRC to sort it out at the end of the tax year

‘Taking out more than you need and putting it in a current or low-interest savings account, for example, means you lose that potential for growth, and as costs rise with inflation this means you can afford to buy less with your savings.’

Pethers agrees that you should withdraw what you need, and be mindful of staying within the tax thresholds.

‘Withdrawing less than £50,271 from your pension (and any other income sources) will ensure you only pay tax at a basic level of 20 per cent.

‘However, if you withdrew £50,271 or over you would move into the higher tax bracket. The benefit of pension drawdown enables you to vary your retirement income from year to year which allows you keep it within a certain threshold.

‘You should also think about what other assets you have available, for example, if you have sufficient savings within your Isa you can withdraw this as tax-free income without impacting your tax bracket. This is one reason why Isas alongside pensions can be very useful in retirement.

Selby says: ‘It might be tempting to take large chunks of your pension money out as soon as you can, but this comes with a serious health warning.

‘Firstly, if you make big withdrawals from your pot, you might end up paying more to the taxman than is necessary. For example, someone with no other taxable income who takes £100,000 out of their pension will have the chunk above £50,271 taxed at 40 per cent.

‘If, on the other hand, they took five withdrawals of £20,000 over five tax years, they shouldn’t ever pay a tax rate of more than 20 per cent (assuming income tax rates remain the same). This could save you thousands of pounds.

‘Secondly, taking too much, too soon from your retirement pot increases the risk of you running out of money early.

‘Finally, if you take money out of a pension and simply shove it in a bank account, it risks having its value eroded rapidly by inflation.’ 

6. Taking early retirement

If you have a final salary – also known as defined benefit – pension then taking it early might be subject to a penalty, explains Pethers.

However it might be worth it, because there could be a reduction in income but you get it for a longer period, she says.

‘This could, for example, potentially put you in a lower rate tax bracket, or bring benefits below the lifetime allowance. However, you might want to consider what other savings you could access first, such as Isas or other investments.’

7. Beware the lifetime allowance

‘The lifetime allowance is the total amount of money you can build up in your pension pots without paying extra tax charges,’ says Alice Shaw of Succession Wealth.

‘The lifetime allowance is currently £1,073,100 for the 2022/23 tax year. If you go over the LTA you will pay a tax charge on the excess whenever you take income or withdraw a lump sum from your pension.’

Shaw says there is also a lifetime allowance test at age 75 for any untouched benefits. She notes that in some circumstances higher lifetime allowance protection may be available.

This is a complicated area and if your pension savings over your working life are approaching or have breached the lifetime allowance, it is sensible to turn to a financial adviser or planner for help.

Pethers says: ‘The amount of tax you pay depends on how you draw the money and can amount to 55 per cent on the excess if you take it as a lump sum or 25 per cent plus your annual rate of income tax if drawn as an income.

‘A good adviser will be able to work out a plan to create a tax-efficient drawdown strategy.’

8. Avoiding inheritance tax

‘Pension plans can be a great way to pass your money on to whoever you want to inherit it,’ says Holt.

‘Inheritance tax isn’t normally payable on your pension savings. However, as wills don’t usually cover pension plans, it’s important to tell your pension providers who you want your money to go to on your death.

‘You can do this by nominating your beneficiaries and keeping these details up to date. If you haven’t done this, your providers will take your wishes in your Will into account but cannot be bound by them.’

>>>Who pays inheritance tax? Not everyone is liable so check key thresholds here

Shaw says you can maintain the value of pension and draw from alternative sources in order to reduce the level of inheritance tax your beneficiaries might pay, if your estate exceeds the thresholds.

‘Under current legislation your pension will not be subject to inheritance tax in a vast majority of circumstances. Therefore you may wish to consider depleting other assets outside a pension first, such as using savings and investments.

‘Remaining pension pots can be passed to beneficiaries to spend tax-free, if the pension pot holder dies before their 75th birthday, or subject to their marginal rate of income tax should death occur after age 75.’

Shaw also suggests using ‘phased’ pension drawdown, by making regular withdrawals of both tax-free and taxable income – see the ‘Taking a 25% lump sum’ section above for more on how to do this.

‘Using this method can allow you to draw an income while paying less tax and manage your income flexibly around income tax bands,’ says Shaw. ‘This option can also avoid you withdrawing lump sums from your pension which could increase inheritance tax liabilities.’

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