How to defend your pension from the taxman: Eight tips from the experts

No one wants to save up all their working life for a decent retirement only to get stuck with an avoidable tax bill.

Unfortunately, there are many tax traps for the unwary when it comes to pensions. 

It’s especially important to find out about them if you don’t get financial advice when you start tapping your fund.

Tax-free lump sums were left untouched by Chancellor Rachel Reeves in the Autumn Budget, but many people made withdrawals as a precautionary measure beforehand. 

One important Budget change was that pensions will now be included in the assets that count towards inheritance tax, if your estate is big enough to pay the levy. 

We asked pension experts for their tips on what trips people up the most often, and how to keep a retirement fund as safe as possible from the taxman.

‘How you take your money from your pension is equally as important as building your savings up in the first place,’ says Jenny Holt, managing director for customer savings and investments at Standard Life.

‘If it’s not given the time, effort and energy required the consequences can have a significant impact on your income throughout retirement.

‘For example, the amount of income tax you pay can depend on the way you decide to access your pension, which means you could end up paying more tax than you need to.’

1. Taking a 25% lump sum

When you access your pension savings, you can normally take a quarter of your total pot tax free at the start, says Holt.

However, you can also benefit from this tax perk in slices if your pension plan lets you, getting 25 per cent tax free and paying your marginal income tax rate on the rest of each withdrawal you make over the years.

‘If you have a defined contribution pension, when you take your tax-free entitlement is up to you, provided you are over 55,’ explains Holt.

‘You can take it all at once, but you don’t have to – and it’s important to remember, once it’s gone, it’s gone.’

Holt notes that the longer your money stays untouched inside your pension plan, the more potential it has to grow in a tax-efficient way and the higher your tax-free entitlement could be – though she cautions that’s not guaranteed and pension investments can go down in value as well as up.

Amy Pethers, wealth adviser at RBC Brewin Dolphin, says: ‘The headline rate of pension tax-free cash is 25 per cent, but some pension savers with older style company pension schemes may find that they have a greater amount of protected cash available.

‘Yet many people in these occupational schemes often forget that they are eligible for this. It is always worth enquiring about your pension’s benefits, rather than assuming they are the same as other schemes.’

If you have a large pension pot, there was an important change following the ditching of the lifetime allowance in April 2023 – the £1,073,100 total limit people could have in their pension pot without facing tax penalties.

The 25 per cent tax free lump sum has been capped at £268,275 – a quarter of the old lifetime allowance limit.

However, if you have fixed protection relating to a previous more generous lifetime allowance level your higher 25 per cent lump sum figure can apply, even if you start paying into your pension again. 

There is more on the old lifetime allowance below, but fixed protection is a complicated area and it is best to seek financial advice about it.

2. Annual allowance limits

The annual allowance is the standard amount you can put in your pension every year and qualify for tax relief on what you saved.

In April 2023 it was hiked from £40,000 to £60,000, or up to 100 per cent of your annual earnings if they are lower than this new more generous allowance.

The annual allowance includes your own and your employer’s contributions into a pension, and the tax relief itself.

The rules are more complicated for higher earners, whose annual allowance was previously tapered down to as little as £4,000, but from April 2023 this changed to a more generous £10,000.

The annual allowance starts being tapered down for people with an adjusted income level – which includes pension contributions – of £260,000.

It is reduced by £1 for every £2 of ‘adjusted income’ above that figure, but only down to the new amount of £10,000.

One very important perk of the annual allowance is that you can still benefit from any of it left unused over the three previous tax years, under certain conditions – you need to have set up a pension already to qualify. We explain the ‘carry forward’ annual allowance rules here.

If you go over the annual allowance this is not illegal, but you will effectively not get any tax relief on any excess pension contribution, because that amount will be added to your taxable income and subject to income tax. This is known as the annual allowance charge.

3. Starting to dip into your pot

When you start tapping a defined contribution pension pot for any amount over and above your 25 per cent tax free lump sum, you are only able to put away £10,000 a year and still automatically qualify for valuable tax relief from then onward.

This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance’. 

This allowance is intended to put people off recycling their pension withdrawals back into their pots to benefit from tax relief twice.

It stops anyone who has made a withdrawal, beyond their tax free lump sum, from benefiting too much from valuable tax relief on contributions from then onward.

The MPAA was originally £10,000 when it was introduced in 2015, alongside pension freedoms that made it much easier to tap pensions from the age of 55.

It was reduced to £4,000 in 2017, but was raised again in April 2023. 

Pension industry experts successfully argued the lower figure was a barrier to retirement saving for people who want to return to work and boost their pensions while doing so. 

Holt says: ‘It’s important to understand how taking your pension money could affect the amount you can pay in. 

‘Once you start flexibly accessing any taxable income from your pension savings, the amount that can be paid into any of your pension plans while still getting tax benefits will be limited.

‘If an employer contributes to your pension, it’s worth calculating if you’d continue to benefit from their full contribution while also drawing a pension income.’

Tom Selby, director of public policy at AJ Bell, says: ‘Hundreds of thousands of savers have flexibility accessed their retirement pot each year since the pension freedoms launched in April 2015.

He warns that once you make a taxable withdrawal and have your pensions annual allowance cut there is no going back. You also lose the ability to carry forward any unused allowances from the three previous tax years.

Selby suggests if you want to access your pension but are concerned about triggering the MPAA, you should consider just taking your tax-free cash, particularly if you are planning a one-off purchase rather than taking a regular income at that point.

He adds: ‘If you are aged 55 or over and have a small pension pot worth £10,000 or less, it is possible to access this without triggering the MPAA. The whole pot must be withdrawn and it will taxed in the same way as an ad-hoc lump sum withdrawal, with 25 per cent tax-free and the rest subject to income tax.’

‘Up to three personal pension pots can be treated as small lump sums in your lifetime, and an unlimited number of occupational pensions.’ 

4. The emergency tax trap

When you reach retirement, it is very important to plan your income carefully in the first year to avoid HMRC levying emergency tax, warns Amy Pethers of Brewin Dolphin.

‘If you take several large sums from your pension over a few months, this may push you into a higher-rate tax bracket and you could temporarily be subject to emergency tax as HMRC may think you plan on doing this for the rest of the tax year.

‘It often makes more sense to spread the cash that you take from your pension over the months and proceeding years so that you have a clear plan in place cognisant of the tax that you will be paying.’

Hundreds of millions of pounds has been repaid to people overtaxed on their withdrawals since pension freedoms were launched in 2015, says Selby.

He explains how emergency tax works, and how to get it back from HMRC, as follows: ‘Your first taxable withdrawal of the tax year will usually be taxed on an emergency basis ‘month one’ basis by HMRC.

‘This means that the Revenue essentially assumes you are making 12 withdrawals rather than just the one.

‘This isn’t a problem if you are taking a regular income as HMRC will adjust your tax code, but if you take a single withdrawal you could end up being overtaxed by thousands of pounds.’

Selby says you can get the money back through your self-assessment tax return, or by filling out one of three forms:

P50Z – if the payment used up your pension pot and you have no other income in the tax year

P53Z – if the payment used up your pension pot and you have other taxable income

P55 – if you have withdrawn only part of your pot and you’re not taking regular payments.

He adds: ‘HMRC says this should get sorted within 30 days. If you don’t fill out one of these forms, you will be relying on HMRC to put you back in the correct position at the end of the tax year.’

5. Your personal allowance and income tax

‘When and how you take your pension can make a big difference to how much tax you pay,’ says Jenny Holt of Standard Life.

‘Taking money little and often can make all the difference so that you don’t pay more tax than you need to.

‘Most people will have a personal income tax allowance that means they don’t have to pay tax on the first £12,570 of their income (for the year 2024/25), such as salary or rental income.

‘Although, if your yearly income is over £100,000, you may not get all this personal allowance, and also your own personal circumstances, including where you live in the UK, will have an impact on the tax you pay and laws and tax rules may change in the future.’

The personal allowance is reduced by £1 for every £2 of income above the £100,000 limit, down to zero. The Government has a full rundown of income tax rates and allowances including rates in Scotland.

Holt explains that when you make withdrawals from a pension over and above the 25 per cent tax-free lump sum, it’s taxable just like any other income, and so is the state pension when that kicks in.

She says taking little and often from your pension has several benefits. You can stay in the lowest income tax band possible, and retain more of your money overall during retirement, and also keep your money invested with the potential for growth.

‘Taking out more than you need and putting it in a current or low-interest savings account, for example, means you lose that potential for growth, and as costs rise with inflation this means you can afford to buy less with your savings.’

Pethers agrees that you should withdraw what you need, and be mindful of staying within the tax thresholds.

‘The benefit of pension drawdown enables you to vary your retirement income from year to year which allows you keep it within a certain threshold.

‘You should also think about what other assets you have available, for example, if you have sufficient savings within your Isa you can withdraw this as tax-free income without impacting your tax bracket. This is one reason why Isas alongside pensions can be very useful in retirement.’

Selby says: ‘It might be tempting to take large chunks of your pension money out as soon as you can, but this comes with a serious health warning.

‘Firstly, if you make big withdrawals from your pot, you might end up paying more to the taxman than is necessary.’

For example, someone with no other taxable income who takes £100,000 out of their pension will have the chunk above the higher rate threshold taxed at 40 per cent, he points out.

‘If, on the other hand, they took five withdrawals of £20,000 over five tax years, they shouldn’t ever pay a tax rate of more than 20 per cent (assuming income tax rates remain the same). This could save you thousands of pounds.’

‘Secondly, taking too much, too soon from your retirement pot increases the risk of you running out of money early.

‘Finally, if you take money out of a pension and simply shove it in a bank account, it risks having its value eroded rapidly by inflation.’ 

6. Taking early retirement

If you have a final salary – also known as defined benefit – pension then taking it early might be subject to a penalty, explains Pethers.

However it might be worth it, because there could be a reduction in income but you get it for a longer period, she says.

‘This could, for example, potentially put you in a lower rate tax bracket, or bring benefits below the lifetime allowance. However, you might want to consider what other savings you could access first, such as Isas or other investments.’

7. The old lifetime allowance

Former Chancellor Jeremy Hunt ditched the £1,073,100 total limit people can have in their pension pot without facing tax penalties, but there are still important legacy rules, so it is not as simple as that. 

He was expected to increase the limit to £1.8million rather than abolish it outright, so this was an eyecatching but controversial move to keep higher earners in the workforce.

Pension experts predict a flood of new money into pensions from the better off – though this might be stymied by new inheritance tax rules, which are explained below.

If you have this much in your pension you should seek professional help to avoid any costly mistakes. As a rule of thumb, paid for advice becomes better value for money as you get wealthier.

Here are the basics:

– As with the annual allowance, under the old lifetime allowance you could keep saving above it but you faced charges which clawed back any tax relief – a 25 per cent charge on income, and 55 per cent on a lump sum. 

The 25 per cent charge was abolished, but the 55 per cent tax charge on lump sums was replaced by marginal rate income tax.

– There is a limit or allowance for the tax-free lump sum you can take from your pensions.

The cap on this is £268,275 – a quarter of the old lifetime allowance limit.

That is unless you have ‘fixed protection’, which allowed people to freeze their lifetime allowance at older, higher limits as long as they stopped making further contributions.

– There is another allowance that relates to tax-free lump sums after death, which is £1,073,100 and includes previous tax-free lump sums and serious ill health lump sums taken while the pension holder was alive.

– And there is an overseas transfer allowance, which again is £1,073,100 and covers pensions moved to ‘qualifying recognised overseas pension schemes’, known as QROPS. 

The rules on transferring QROPS changed in the Budget and it is best to get help from a financial adviser with relevant expertise and regulated in the UK on anything to do with them.

When the lifetime allowance was introduced by Labour in 2006 it was £1.5million, but this was gradually raised to reach £1.8million in the 2010/2011 tax year.

However, it was then slashed by Conservative Chancellors George Osborne and Philip Hammond, falling all the way down to £1million in 2017/2018, before being moved gradually up again.

8. Avoiding inheritance tax

Chancellor Rachel Reeves announced in the Autumn Budget she plans to make defined contribution pensions liable for inheritance tax like other assets such as property, savings and investments starting from April 2027.

At the same time, discretionary death benefits are also going to be brought into estates for inheritance tax purposes. 

Family legacy plans have been upended by the news on pensions, because retirement pots are treated generously by the taxman when people die at present, especially if that is before age 75 when they are tax free.

They have therefore become widely used as a way to pass wealth down the generations, and are often spent last (if at all) by people whose estates could be hit by inheritance tax at 40 per cent.

Read about how inherited pensions are still taxed at present here, but be aware that the Government says it is ‘removing the opportunity for individuals to use pensions as a vehicle for inheritance tax planning’ so if that was your intention you should review this over the next couple of years.

Wealthy families could face a particularly harsh ‘double tax hit’ on inherited pensions of up to 70.5 per cent under the new rules.

Options to mitigate the impact touted by finance experts so far include making large withdrawals – beyond your 25 per cent tax-free lump sum, the threshold at which point income from all sources starts being taxed at 40 per cent is £50,270 – making bigger gifts within the seven year rule, and greater use of Junior Isas.

Meanwhile, Jenny Holt of Standard Life says: ‘As wills don’t usually cover pension plans, it’s important to tell your pension providers who you want your money to go to on your death.

‘You can do this by nominating your beneficiaries and keeping these details up to date. If you haven’t done this, your providers will take your wishes in your will into account but cannot be bound by them.’