Eight ways to avoid paying too much tax in retirement

No-one wants to pay more tax than they need to at any stage of life, but it’s particularly important to make sure you’re not overpaying in retirement when drawing down on your savings.

The key to reducing how much tax you pay is by looking at the order in which you take your pension and other savings. In fact, prioritising which savings you use up first can be almost as important as saving itself, and can also help you to leave more money to your loved ones as an inheritance.

Here, Telegraph Money outlines eight ways to reduce tax on your retirement savings, and help them to last longer.

1. Don’t rush into withdrawing your money

Pensions, Lifetime Isas and other Isas will continue to grow tax-free when you’ve reached retirement, so you should try to avoid taking money out of these kinds of accounts until you actually need the income. 

Not only could you forfeit the tax-free status of the cash you withdraw, taking income from a “flexi-access” drawdown account while you’re still working and saving into the pension will severely limit the amount you can continue to save tax efficiently. 

This is because the “money purchase annual allowance” (MPAA) is triggered when defined-contribution style pensions are accessed, cutting your tax-free pension allowance to £10,000 from £60,000.

If you’re concerned about your pension’s investment performance, or uncomfortable with the level of risk as you get closer to needing to make withdrawals, don’t be tempted to withdraw cash to save into a bank account or cash Isa. 

Instead, consider moving your pension into lower risk funds to avoid large market fluctuations.

2. Use your Isa savings to provide an initial retirement income

Isas can also be used to provide a retirement income, which won’t affect your tax-free pension contributions if you’re continuing to save. 

Withdrawals are tax-free, but they can come with other penalties, depending on the type of Isa you have, so be sure to check the terms and conditions first. 

Fixed-term cash Isas, for example, may allow withdrawals before the end of the term, but you’ll often pay an interest penalty. 

Lifetime Isas, on the other hand, only offer penalty-free withdrawals once you’re over the age of 60 – before this, you’ll lose 25pc on the amount being withdrawn.  

If you are able to draw a regular income from Isa savings, doing this can be a helpful way to top up your income when moving from full-time work to reduced hours, to full retirement. 

Using this money first means you can keep paying up to £60,000 into your pension tax-free, and is prudent from an inheritance tax perspective as Isas form part of your estate. 

There are, however, special tax rules between spouses and civil partners who can inherit their partner’s Isa allowance.

3. Consider taking your pension tax-free cash sum 

You can usually take up to 25pc of your pension fund tax-free, from age 55 (due to rise to 57 in 2028), and doing this won’t affect the amount of tax you pay. 

You have to purchase an annuity or go into drawdown at the same time as taking your tax-free cash sum. 

Taking a 25pc cash sum will not trigger the MPAA, as long as you don’t take any extra withdrawals from your drawdown account.

4. Make the most of your personal tax allowance

If your income is less than the personal tax allowance (£12,570) you won’t pay any income tax. You can continue to be free of income tax by making sure you don’t exceed this threshold when you come to draw down your pension. 

If you have a spouse or civil partner who is a basic-rate taxpayer, keeping your own income at £11,310 you can also benefit from the marriage allowance, where you essentially transfer 10pc of your personal tax allowance to your partner, which cuts your household’s income tax bill by £252 a year.

However, if you are still saving in a pension – or think you may start again at a future date – you’ll only be able to save up to £10,000 a year before triggering the MPAA.

5. Take small pension pots worth less than £10,000 

You can cash in up to three small pension pots – that is, those containing savings of less than £10,000 – from “personal pension” schemes without triggering the MPAA. 

Note that if the small pot payment is paid from “uncrystallised” funds, 25pc will be paid tax-free and the remainder will be taxed as income. If it’s paid from “crystallised” funds, the full amount is taxable.

6. Access your pension last

You should generally access your pension savings last – that is, after using your Isa savings and pension tax-free cash. This is because pension income is taxable under the income tax rules (although, as noted above, income up to £12,570 is tax-free). 

Delaying taking your pension income will help it to last longer, and allow you to continue making higher tax-free contributions if you are still working.

7. Never push yourself into a higher tax bracket

Pension income, including the state pension, is taxable. It’s therefore important to consider all forms of income you receive – including state pension payments, rental and dividend income – when using drawdown in case this pushes you into a higher tax bracket. 

Only take out as much money as you need to fund the lifestyle you want, and that your retirement savings can afford. 

8. Pension savings can be passed to your loved ones tax-free

Pension savings, unlike money held in Isas, generally don’t form part of your estate when you die, so inheritance tax isn’t normally payable. This is another reason to prioritise spending money held in other accounts before turning to your pension.

If you die before your 75th birthday, your unused pension funds can be paid tax-free to your loved ones either as a lump sum or as income, if paid within two years. If you die after age 75, any unused pension fund is taxed at your loved one’s income tax rate. 

This can be significantly cheaper if they are a basic-rate taxpayer, as they’ll be charged 20pc versus the 40pc inheritance tax charge. But, if they’re an additional-rate taxpayer, they’ll be taxed at 45pc.