To minimise tax when you’re retired, it’s first important to understand what tax you do have to pay.
Many people assume that their pension income, especially the State Pension, will be tax-free. That, however, is not the case. Once retired, you must still pay Income Tax on any income over your Personal Allowance. This applies to all your pension income, including the State Pension.
Some income, including your State Pension, is paid without any tax being taken off. But it doesn’t mean that tax isn’t due.
National Insurance contributions are different. Even if you continue working beyond the State Pension age, you do not have to pay National Insurance contributions on your earnings. The new NI Health and Social Care levy (1.25%) is an exception to this though and must be paid, even in retirement. Find out more at gov.uk.
So, now we know that you will be taxed, how can you legally minimise tax when you’re retired? It’s more complex than when you’re in employment but a little bit of planning will help you minimise your tax payments when you’re retired.
Here are my 5 tips:
1) Only Withdraw Money from Your Pension When You Need To
The first way to minimise tax when you’re retired is to try to take only the amount you need in each tax year. Put simply, the lower you can keep your income, the less tax you will pay.
Of course, you should take as much income as you need to live comfortably. Unlike when earning a salary, there’s less advantage to having more income than you need and putting it into savings. In most cases, it’s best to leave money inside your pension until you are sure you are going to spend it.
This is where it can be advantageous to have a drawdown scheme. Drawdown lets you vary your income from year to year, which can potentially lead to tax savings. For example, if in one year you spend £25,000 but in the next year you only need to spend £20,000, you will save £1,000 in tax if you draw down only as much as you need.
If you have an annuity, you won’t have this flexibility. However, drawdown does come with different risks. Talk to me about which option suits your circumstances better.
2) Make Full Use of Tax Allowances
If you’re used to your employer taking care of your tax allowances for you, you should perhaps put some attention on them as you’ll have to manage them yourself once retired. The same applies for the self employed that rely on their accountants for this service.
Your Personal Tax Allowance (PSA) is the amount of income you can earn in a year before paying any tax. Currently this is £12,570 for 2022/23, unless you earn over £100k. Once your income exceeds £12,570, from pensions, property, employment or interest on savings, you pay income tax.
For couples, if you’re married or in a civil partnership and one of you hasn’t used up all your personal allowance for the year (because you’re on a low income), you may qualify for the Marriage Allowance. This lets you transfer an unused personal allowance to your partner.
Regarding savings, don’t forget that you can earn up to £5,000 in tax-free interest, depending on your circumstances. It can be complex, so check with gov.uk for the latest information.
3) Spend your ISA Savings First
ISAs are tax free. So, won’t count towards your income. Therefore, if you’ve built up sufficient ISA savings, it’ll save you income tax, potentially, to spend those rather than drawing down from your pension. See also my point (4) below, as a way of using your pension’s tax-free lump sum.
4) Use Your Tax-Free Lump Sum
Depending on the type of pension you have, you may be able to withdraw up to 25% of its value before paying tax. It really does depend on your individual circumstances though and you should also watch out for provider charges that may eat into your pension pot’s value. It’s worth looking closely though.
If you can withdraw a lump sum tax free, that’s obviously a good way to avoid paying tax, at least initially in your retirement. Or maybe for those home improvements you want to do, or that cruise….
Another option is to then put the tax-free lump sum into an ISA, as long as it’s within the £20,000 p.a. ISA allowance limit. Then you can withdraw at your leisure, tax free.
5) Time Your Retirement to the End of a Tax Year
While this may not be practical or even possible for everyone, if you can, there are good tax reasons for retiring at the end of a tax year.
A lower rate of Income Tax. If you are a higher rate taxpayer, then retiring part way through a tax year is likely to mean your pension income is taxed at 40% (because it’s added on top of your salary). By retiring and taking your pension income at the start of a new tax year will mean you have no salary to add on and therefore your pension income could be taxed at 20%.
- Full Personal Allowance. Retiring part way through the year will probably mean you have already used up your Personal Allowance, so pension income gets taxed straight away.
- ISA allowance. If you receive a tax free lump sum from your pension then by retiring at the end of March you will be entitled to 2 x ISA allowances in quick succession. One for the end of the tax year and another right again at the start of the new tax year from 6th April.
- Capital Gains Tax (CGT) allowance. Similar to the ISA, if you are planning on cashing in investments for your retirement which have made gains, then by doing it at the end of the tax year means you can split your encashments and get a full CGT allowance for the current tax year and a few days later a full CGT allowance for the new tax year.
So, you thought life’d be simpler when you retired?
Sorry, there are always personal financial and taxation complications to factor in. Nevertheless, with careful planning you can minimise tax when you’re retired. Talk to an Adviser like me for up-to-date advice that’s tailored to your personal circumstances. Contact me now.