650,000 more pensioners could pay Income Tax this year: Discover 4 ways to reduce your tax bill in retirement

After saving for many years to fund a comfortable retirement lifestyle, it may feel frustrating to see your income diminished by unexpected taxes.

Unfortunately, according to MoneyWeek, an additional 650,000 pensioners may have to start paying Income Tax in 2024/25.

This is largely due to the increase in the State Pension – which rose 8.5% on 6 April 2024 – and the freeze on the Personal Allowance, which remains at the 2021/22 level of £12,570 (2024/25). Any income you generate that exceeds the Personal Allowance – including your State Pension – is likely to incur Income Tax.

So, while a higher State Pension may sound like welcome news, you may now only need a small amount of income from other sources before you become liable to pay Income Tax.

Meanwhile, careful financial planning could help you mitigate these changes and enjoy the retirement lifestyle you’ve always dreamed of.

Read on to discover four ways to reduce your Income Tax bill if you’re retired.

1. Withdraw the tax-free portion of your pension in instalments

When you reach the minimum retirement age of 55 (rising to 57 in 2028), you can usually withdraw up to 25% of your defined contribution (DC) pension as a tax-free lump sum – up to the Lump Sum Allowance (LSA), which is currently £268,275 (2024/25).

You’ll be charged Income Tax at your marginal rate on any amount over the LSA, and on any withdrawals you make from the remaining taxable portion of your pension pot.

However, you can usually choose to take the tax-free portion of your pension as a lump sum or in instalments.

So, if your pension provider allows you to take your pension as a flexible income – “drawdown” – you could make withdrawals from both the tax-free (typically 25%) and the taxable (typically 75%) portions of your pension pot at the same time.

The benefit of doing this is that it could allow you to enjoy a monthly income from your pension without paying any Income Tax – provided that your taxable withdrawals don’t exceed the Personal Allowance.

Sound complicated? Let’s take a look at an example.

Imagine you withdraw £1,000 each month from the tax-free portion of your pension and £1,000 from your taxable money, assuming you have no other income. Over one year, your taxable income would not exceed the Personal Allowance so you wouldn’t pay tax on either of the £1,000 payments.

2. Supplement your pension with ISA savings and investments

You’re likely to be charged tax on any interest and returns you make from savings and investments held outside of a pension or ISA tax wrapper.

In contrast, you can save up to £20,000 (2024/25) into ISAs each tax year without paying Income Tax on the interest or dividends you receive, or Capital Gains Tax on any profits you make from investments. What’s more, you won’t be taxed on withdrawals from an ISA.

So, supplementing your pension income with ISA savings and investments could be a smart way to keep your retirement income as tax-efficient as possible.

The government introduced several changes to the ISA rules on 6 April 2024, which make them more flexible and, potentially, an even more attractive option for savers.

Additionally, a new UK ISA is currently under consultation. If introduced, this could potentially boost your annual ISA allowance by £5,000 for UK-based investments.

Read more: ISA changes happening this year: What do they mean for me?

3. Carefully draw your pension income around the tax bands

Income Tax is charged on your taxable income, which includes money taken from your pensions (aside from your tax-free lump sum).

But crucially, the rate at which you pay Income Tax depends on how much income you have above your Personal Allowance and how much of it falls into each of the three tax bands:

• Basic rate – charged at 20% for taxable income between £12,571 and £50,270
• Higher rate – charged at 40% for taxable income between £50,271 and £125,140
• Additional rate – charged at 45% for taxable income over £125,140.

So, by keeping these tax bands in mind, you can carefully construct a retirement income that allows you to live your desired lifestyle without finding yourself in the next tax band above.

For example, if you think that you need an income of £60,000 a year and decide to draw this from your pension, this would likely push a portion of your income into the 40% higher-rate tax band.

Meanwhile, you could instead draw £50,000 of taxable income from your pension, and then top this up to your desired £60,000 income using your pension tax-free lump sum and money held in ISAs. That way, you can still enjoy the same level of income, but you wouldn’t have to pay the higher-rate tax charge.

Working with a financial planner can be powerful here. We can use cashflow modelling to project the income you would need for your desired retirement lifestyle, using your goals for the future to accurately calculate what this will cost.

Then, we can take a holistic look at your wealth and help you design a tax-efficient income strategy. We can consider all the various sources you have available, balancing taxable sources of income such as pensions and property with tax-free elements such as your lump sum and your ISAs.

That way, you can enjoy the lifestyle you want using your hard-earned wealth, without seeing it eaten into by an excessive tax charge.

4. Consider passing your pension on to loved ones

Creating a tax-efficient retirement income isn’t always just about you – it can also be about helping your family pay less tax when they inherit wealth from you.

Fortunately, a pension isn’t usually considered part of your estate for Inheritance Tax (IHT) purposes. So, if you have other sources of income to use during your retirement, such as ISAs and property, you might want to consider preserving your pension and creating an estate plan that leaves your pension to a family member.

Your loved ones could then benefit from your pension as either a tax-free lump sum or an income. While this may not necessarily make your retirement income more tax-efficient, it could protect your family’s inheritance from tax after you’re gone.

However, your unused pension funds can only be passed on tax-efficiently if you die before your 75th birthday and the money is paid within two years. If you die after the age of 75, any unused pension funds will be taxed at your beneficiary’s Income Tax rate – although they will still be free from IHT.

Get in touch

Getting to grips with tax rules and how they might apply to your retirement income can be complicated.

So, if you’ve retired and would like to make your income as tax-efficient as possible, please contact us by email at info@lloydosullivan.co.uk or call 020 8941 9779 to see how we can help you.

Please note

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

The Financial Conduct Authority does not regulate estate planning or tax planning.

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 performance.

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.

Workplace pensions are regulated by The Pension Regulator.

The value of your investments (and any income from them) 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.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.