Retirement and tax: Are you paying too much?

When it comes to planning your retirement income, there’s a lot to think about:

  • What’s a sustainable level to withdraw?
  • Should you choose a guaranteed income?
  • How much do you need annually?

It’s not surprising that the tax implications are often being missed out. But it could have an impact on your income and how your savings will stretch.

The income you receive in retirement may still be liable for Income Tax if the total exceeds the Personal Allowance, which is currently £12,500. Your income includes payments you receive from the State Pension, an Annuity and regular and one-off withdrawals you make from your pension. You may also be earning income from other sources in retirement too, for example, if you continue to work. As a result, you may end up paying more tax than you anticipated.

The same tax bands apply in retirement as those when you’re employed. For the 2019/20 tax year, these are:

Band Taxable income Rate
Basic rate £12,501 to £50,000 20%
Higher rate £50,001 to £150,000 40%
Additional rate Over £150,000 45%

 

During 2017/18, pensioners collectively paid £18.4 billion in Income Tax, the latest figures from HM Revenue & Customs show. This sum is around £4 billion higher than expected, as the statistics are now based on real-time information rather than the results of a sample survey.

Steve Webb, former Pensions Minister and now Director of Policy at Royal London, said: “It is outrageous that the government has sneaked out these massive revisions to the figures for the amount that pensioners pay in tax without any comment.

“It is clear that pensioners who have worked hard and saved hard are putting billions back into the economy through the tax on their pensions.”

While tax is often said to be one of the two certainties in life (the other being death) there may be ways you can reduce your liability when in retirement.

Deferring the State Pension

Your State Pension is liable for Income Tax should other forms of income mean you’re earning more than the Personal Allowance. With this in mind, it can be worthwhile deferring your State Pension for a period, for example, if you choose to continue working past traditional retirement age.

Assuming you have 35 years on your National Insurance record, the full State Pension amounts to £8,767.20 annually, taking up a sizeable chunk of your Personal Allowance. Research from Royal London suggests there are around 520,000 people in the workforce that are above State Pension age and earning more than £12,500. If you’re in this situation, deferring the State Pension could mean you pay less Income Tax now.

Deferring your State Pension also has the added bonus of increasing the amount you’ll receive when you do claim it. For every nine weeks, it will increase by 1% or 5.8% if you defer for a year. Though of course, if you defer for an extended period of time, it could mean paying more tax at a later date. Alternatively, you can also choose to receive a one-off lump sum payment if you defer for at least 12 months in a row. This will include interest of 2% above the Bank of England base rate, which is currently 0.75%.

Deciding how to take your income

Since 2015, there’s been more flexibility in how you can access your pension. As well as leading to questions around which option is the best for you and potentially ensuring your provisions last a lifetime, your choice will have tax implications.

When you decide to access your pension, there are three main options:

1. Annuity: An Annuity is a policy you purchase, which then provides you with a guaranteed income for life. In some cases, the amount paid out can be linked to inflation to maintain spending power. As the payments are regular, the amount of Income Tax you pay will be predictable too. Once you purchase an Annuity, it’s not a decision you can reverse. As a result, it’s worth considering your tax position before going ahead.

2. Lump sum: In most cases, you’re able to access your pension from the age of 55, including withdrawing a lump sum. However, usually, only the first 25% is tax-free. You have two routes here, which may affect when and how much tax you pay.

The first option is to withdraw a single lump sum up to 25%, typically receiving all of it without paying tax. With the remaining 75%, you could either purchase an Annuity, use Flexi-Access Drawdown or continue taking lump sums, though further lump sum withdrawals would be liable for Income Tax and is often not a tax-efficient way to access your pension.

The second option is to take lump sums as needed. Normally, 25% of each withdrawal will be tax-free, with the remaining taxed at your standard Income Tax rate. You should carefully think about how taking a lump sum will add to your overall income for the tax year. In some cases, you may be better off reducing the lump sum you take or waiting until a new tax year to make a withdrawal.

Should you choose to, you can take your entire pension as a single lump sum. 75% of this would be liable for Income Tax and it’s often not efficient. You should also ensure that you have either a plan or alternative provisions to support you financially throughout retirement.

3. Flexi-Access Drawdown: This is an option that allows you to access your pension flexibly. It usually remains invested and you control when you receive an income and how much it is. Money withdrawn through Flexi-Access Drawdown will count as income and you may, therefore, need to pay Income Tax on it. As you take responsibility for your income with this option, it’s important to understand how your decisions could affect the level of tax you pay.

With Flexi-Access Drawdown there are a lot of areas to consider, including making sure your pension lasts a lifetime. As a result, tax may be something you’ve overlooked. But timing your withdrawals, understanding the level of income needed and considering when you’ll need to take an income over the course of a tax year can help you minimise Income Tax.

Getting to grips with Income Tax on retirement income can be challenging, especially as now there are several options. This is an area we can help you with in the context of a wider financial plan.

Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implication of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.