Don't pay too much tax in retirement

Did you realise you still pay income tax after you’ve retired? Here’s what you need to know — and how it affects your retirement options.

Tax just never goes away. When you stop working, you could still have an income — from any work or private pensions, from the State Pension if you’ve reached State Pension age, plus possibly from other investments. And if your total income’s high enough, you’ll still be paying income tax.

There’s some good news. If you’re not in work, you won’t be paying National Insurance contributions. But the tax you pay, and at what rate, will continue to depend on your total annual income, wherever it’s coming from.

If you’ll be receiving a steady income in retirement, it’s easier to plan. But with the range of pension options available — such as taking cash sums or withdrawing a flexible income — you need to be careful to make sure you don’t pay more tax than you’re expecting to.

A reminder about income tax

Tax rules are subject to change and depend on your personal circumstances.

Everyone has a standard personal allowance, which is the amount of income you don’t need to pay tax on. For the tax year 2020/21 it’s £12,500. This may sound quite a reasonable amount in retirement, but the full new State Pension is currently £9,110 a year. Your own State Pension may differ based on your personal circumstances, but if you get the full amount that’d only leave another £3,390 of income before you reach the threshold. You could be taxed on any income above that.

Basic rate income tax is currently 20%, but if you earn enough to be a higher or additional rate taxpayer (or an intermediate, higher or top rate taxpayer in Scotland), you’ll be paying more. You may think these rates won’t affect you in retirement, especially if you’ve never paid higher rate tax in the past, but what if you made a large withdrawal from your pension fund in one tax year, for example?

If you’re winding down gradually, working part-time while starting to take some retirement income, you also need to think about tax. This gradual approach is likely to put your total income over the tax threshold, so effectively you’ll be taxed on more of your pension income.

Don't worry, there's still your tax-free lump sum

Under the current rules, not all the money you get from your pensions is taxable. Most schemes allow you take up to 25% of the value of your policy as a tax-free lump sum from age 55.

You can do this in one of two ways. You could take your whole tax-free lump sum in one go with all future income or withdrawals being taxable. Or, you could withdraw lump sums from your pension, or gradually use your fund for other income options, and each time you do this 25% of the amount you use will be tax-free.

Tax and your retirement options

Let’s look at the ways you can access your pension fund and how they could be affected by income tax. (Please note defined benefit schemes, sometimes known as final salary schemes, work differently.)

  • An annuity is a guaranteed income for life. You can use all or some of your pension fund to purchase one. If you do, you can first take 25% of the amount as a tax-free lump sum, which doesn’t count towards your personal allowance. The guaranteed income you then get from your annuity is taxable if your total income is above your personal allowance. But you’ll know how much money this is going to be, so you can add it to your other sources of income to get an idea of how much tax you’ll pay overall.
  • Flexible income withdrawals, often known as drawdown, are exactly what they say: flexible withdrawals direct from your pension fund. First you can take 25% of your fund as a tax-free lump sum (or 25% of the amount you’re accessing) then withdraw the rest either as a regular flexible income or as and when you like. The tax-free lump sum doesn’t affect your personal allowance. The subsequent withdrawals are taxable if your total annual income exceeds your tax-free personal allowance. Consider your income from all sources when deciding how much income to withdraw at any point.
  • You can also take cash withdrawals direct from your pension — either the whole lot in one go or individual withdrawals at different times. Each time you do this, 25% of the amount you withdraw will be tax-free. Sounds great, but as well as thinking seriously about the long-term effect on your finances, consider the tax you might pay. For example, if you withdrew £60,000 in one go, you’d get a tax-free lump sum of £15,000, but the remaining £45,000 would be classed as income and taxed to the extent your overall income exceeds your personal allowance. Depending on your total income, some of the £45,000 could end up in a higher tax band. (Please note that in some instances the full withdrawal may be taxed by your pension administrator through PAYE, so you may receive a lower amount than you expect. If this happens you would need to claim a refund of the tax from HM Revenue & Customs.)

If you’re thinking of taking a flexible-income or cash withdrawal, our pension-withdrawal tax calculator can help you see how much tax you may need to pay.

If you’re planning to access your pension and subsequently make further contributions into it, please note that any withdrawal you make could reduce the tax relief on those contributions. Here’s how to check if this will affect you.

Finding the optimal mix

There are many reasons why people mix and match their retirement options and it’s mostly to do with flexibility. And this flexibility can help when it comes to tax planning.

Using a combination of withdrawal options — or making the most of the flexibility they offer — can help you receive your pension income in the most tax-efficient way over the years.

As you can see, planning your retirement income can potentially get very complicated, especially if you’re taking a flexible income or withdrawing cash sums. We recommend that you discuss your requirements with your financial adviser. They’ll be able to talk you through your options and work out what’s best for you. If you don’t have an adviser, we can help put you in touch with one. Call us on 0800 302 9656, Monday to Friday 9am-5pm.

Please note: Not all pensions have the flexibility we’ve described here, but if yours doesn’t you may be able to transfer to one that does. If you’re considering transferring a pension, again we recommend talking to your financial adviser as you could be losing out on valuable guarantees with your existing policy. Some transfers may require you to seek advice before you can go ahead. Any use of financial advice may be subject to a charge.