3 need-to-know pension tax rules to be aware of before you retire

Pension Awareness Week is upon us, falling this year between 11 and 15 September. This week offers the perfect opportunity to better your understanding of pension tax rules and how pensions work, which could enable you to get more from yours in retirement.

One complex subject that could be of interest as you approach retirement, or if you’re already retired, is tax. As you transition from working life to retired life, you might seek more clarity on how you’ll pay tax once you stop working and start drawing from your various sources of retirement income.

Sadly, as the cost of living remains high, Sky News reports that 1 in 3 people could struggle to make ends meet in retirement. As such, making the most of what you’ve got, and reducing your tax bill where possible, is crucial.

So, here are three need-to-know pension tax rules to be aware of before you retire, and how we can help you stay tax-efficient when you enter this new chapter.

1. You may pay Income Tax when drawing from your personal pension pot

Your defined contribution (DC) pension, also known as your “personal pension pot”, may make up a large portion of your later-life income. 

The way you draw from this pension pot will likely have an effect on your tax bill. There are typically two methods of drawdown: taking the whole pot as a lump sum, or opting for flexi-access.

Whichever option you choose, you can take a 25% tax-free lump sum.

However, if you take the entire pot at once, the remaining 75% of your pension may be subject to your marginal rate of Income Tax, meaning you could pay up to 45% tax on a large portion of your fund.

What’s more, lump sum withdrawals can sometimes trigger an emergency tax code, leading to many pension holders paying higher tax than they should upon their first withdrawal. 

Indeed, FTAdviser reports that instances of overpaid tax in the second quarter of 2023 were almost double the number reported in the same time frame of the previous year. This has led to HMRC returning £56 million in overpaid tax to those who accessed their pensions in that quarter.

Fortunately, flexi-access can be a more tax-efficient method of taking your DC pension. The same rule applies – 25% of a withdrawal is tax-free, and the remaining 75% may attract Income Tax – but when taking smaller amounts over time, this could keep you in a lower tax bracket.

2. Your defined benefit pension may attract Income Tax too

If you have a defined benefit (DB) pension, also known as a “final salary” pension, this income will also be subject to Income Tax as if it were a regular salary.

So, if you expect to receive a sizeable DB pension income upon retirement, it’s important to factor in the tax bill you may pay on this sum. 

Similar to any other income, your Personal Allowance, which stands at £12,570 as of the 2023/24 tax year, applies to your pension earnings. You can earn up to this amount without paying Income Tax or National Insurance contributions (NICs). Any earnings above this threshold are subject to Income Tax at your marginal rate.

3. If you have multiple sources of income, these are combined to form your tax liability in retirement

Calculating how much tax you might pay in retirement can be tricky when you have multiple streams of income. The most important thing to remember here is that many of your income sources will be combined to form an overall Income Tax bill. 

This could include money from your:

  • State Pension
  • DC pension
  • DB pension
  • Part-time work
  • Properties (such as rental homes).

What’s more, you could be relying on money from your investment portfolio to make up a portion of your retirement income – and this could incur a Capital Gains Tax (CGT) bill. 

While ISA profits aren’t subject to CGT or Income Tax, cashing in on other investments could mean you pay CGT on income from: 

  • Non-ISA shares 
  • Business holdings
  • The sale of a property that isn’t your main home, unless the home is very large
  • Other belongings you own worth more than £6,000, apart from your car.

So, in addition to being aware of your potential Income Tax bill, it’s also essential to understand that you could pay CGT in retirement too.

Working with a financial planner can help you take a tax-efficient income in retirement

Organising an income in retirement can be complex. 

If you’ve been used to having one or two forms of income in your working life, drawing from a selection of sources might feel overwhelming at times – especially when you’re trying to keep your tax bill low.

That’s where personalised financial planning can come in. If you’re approaching retirement, or already taking your pension, working with a professional can put your mind at ease and help position your finances favourably for the years to come.

If you’d like to learn more about pensions, tax, and any other retirement matters this Pension Awareness Week, email me at a.douglass@grosvenorconsultancy.co.uk or call my office on 01793 766 123. Alternatively, call my mobile on 07525 177 046. 

While I offer high standards of service and will work with you to ensure any plan is right for you, I’m also a busy mum, so work Mondays and Tuesdays only.

Please note

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

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

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.  

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