Pensioners facing rising income tax bills can slash their payments by hundreds or thousands of pounds using four zero-cost financial strategies, wealth management experts have advised.
Figures from pensions consultancy LCP show that the number of pensioners paying the higher 40 per cent rate of income tax has doubled over the past five years alone to well over one million people.
Retirees are handing over an increasingly large share of their income to HM Revenue and Customs each year, leaving them with less money to live on and enjoy in retirement. Even individuals with modest incomes on top of their state pension now face tax bills. However, financial experts stress that changing the order and combination in which assets such as pensions, Individual Savings Accounts (ISAs), and cash savings are spent can significantly reduce overall tax liabilities.
David Little, partner at wealth manager Evelyn Partners, suggested viewing retirement income like a jigsaw puzzle. "A household might have pensions, Isas, cash, investment accounts and tax-free pension cash available," he said. "The order and mixture of those jigsaw pieces and how they are used can make a surprisingly large difference."
Using annual personal tax allowances
A common error made by early retirees is spending savings held in ISAs first while leaving pension pots untouched. This approach has been popular because pensions can currently be passed on free of inheritance tax, prompting retirees to hold onto pension funds for loved ones while drawing down other assets.
However, rules change in April next year so that pensions lose this advantage, meaning it will no longer be preferable to hold onto them for inheritance tax reasons. Spending pensions alongside other savings can prove highly advantageous.
For example, a person retiring at age 60 who requires £25,000 a year to live on faces a seven-year gap before receiving the full state pension at age 67. Withdrawing £25,000 annually solely from ISAs during those seven years results in zero tax because ISA withdrawals are tax-free. However, this strategy fails to make use of the individual's annual £12,570 tax-free personal allowance.
If the retiree instead withdraws £12,570 a year from their pension for those seven years, no income tax is due because the sum remains within the personal allowance. This allows a total of £87,990 to be taken from the pension completely tax-free. If that £87,990 were instead withdrawn after state pension payments start, almost every penny would be taxable because the state pension uses up virtually all of the personal allowance. For a basic rate taxpayer paying 20 per cent, this creates a potential tax bill of £17,598.
Little noted that retiring early and living entirely on cash and ISAs until state pension age is one of the biggest mistakes he sees. "Instead, see these intervening years as a valuable tax planning window, making sure you use as much of your personal allowance as possible," he said. The potential tax saving from this strategy stands at £17,598.
Transferring savings between spouses
Every individual has tax-free allowances, including the personal allowance and the personal savings allowance. Exceeding these limits results in paying tax. However, couples who are married or in a civil partnership can move wealth between themselves to maximize the use of both sets of allowances and slash their combined bill.
Consider a scenario where one partner receives the full state pension, has a £10,000-a-year workplace pension, and holds savings generating £10,000 of interest in their own name, while their spouse receives only the full state pension. As the savings are in the first partner's name, all £10,000 of interest counts toward their income. Basic rate taxpayers receive a £1,000 personal savings allowance, so the remaining £9,000 incurs tax. Taxed at the 20 per cent basic rate, this results in an annual bill of £1,800.
If the savings are moved into the spouse's name, far less tax is owed. A spouse receiving the full new state pension of £12,547.60 has £22.40 of their £12,570 personal allowance remaining. Because of their low income, they also benefit from the Starting Rate for Savings, which taxes up to £5,000 of savings interest at 0 per cent. Savers receive the full £5,000 allowance if their other income does not exceed the £12,570 personal allowance, after which it reduces by £1 for every £1 of additional income.
Combined with their £1,000 personal savings allowance, the spouse can receive £6,022.40 of savings interest completely tax-free. That leaves £3,977.60 of the £10,000 interest taxable. If the first partner keeps £3,977.60 in their own name to take advantage of their own £1,000 personal savings allowance, only £2,977.60 incurs tax. Taxed at 20 per cent, the bill drops to £595.52 instead of £1,800. This saves £1,204.48 a year, or £12,044.80 over ten years if rates, allowances, and interest remain unchanged. The potential tax saving is £1,204.48 annually.
Spreading pension tax-free lump sum withdrawals
It can be tempting to take a 25 per cent pension tax-free lump sum all in one go. However, doing so makes all subsequent withdrawals taxable, potentially causing retirees to pay more to HM Revenue and Customs overall. The key is using tax-free withdrawals to keep taxable income below the higher or additional rate tax bands.
Suppose a couple needs £50,000 a year to live on and both receive the full state pension of £12,547.60. They need to find £24,904.80 after tax to meet their target. If they have already taken their full tax-free lump sum in a previous year, the £24,904.80 withdrawn from their pension will be taxable, requiring a gross withdrawal of £31,125.20. State pensions consume almost all of their personal allowances, leaving a combined £44.80. The remainder is taxed at 20 per cent, producing a total bill of £6,220.
If the couple has not yet exhausted their tax-free allowance and holds ISAs to make tax-free withdrawals, the outcome is different. To reach the £50,000 target alongside state pensions, they could take £20,000 from their pensions, including £5,000 tax-free. With £44.80 of personal allowance remaining, only £15,000 of the pension withdrawal is taxable, generating a bill of around £2,991. That means withdrawing £17,009 gross from the pension. Topping that up with a £7,896 withdrawal from ISAs results in paying around £3,225 less tax that year.
Although some of this saving may only be deferred, because funds left in a pension could be taxed when eventually withdrawn, reducing taxable income below higher rate thresholds yields substantial savings. Adrian Murphy, chief executive at wealth manager Murphy Wealth, urged retirees to consider timing. "More people need to think about spreading withdrawals from pensions, especially if they are otherwise tipping into higher-rate tax," he said. The potential tax saving is around £3,225 in that year.
Continuing pension contributions in retirement
Tax relief on pension contributions remains available after retirement, even for individuals with no earnings. A common mistake is assuming there is no point paying into a pension once retired.
Even without earnings, individuals can each pay £2,880 a year into a pension until age 75 and have it topped up to £3,600 by HM Revenue and Customs. If neither spouse has earnings, each paying £2,880 puts £7,200 into their pensions for a total out-of-pocket cost of £5,760, with HMRC adding £720 to each contribution for a combined £1,440 boost.
Retirees who have earnings, such as £5,000 a year from consultancy or part-time work, can contribute more based on those earnings. For example, a £5,000 gross pension contribution requires £4,000 from the saver, with HMRC adding £1,000. However, two limitations apply: pension withdrawals may later be taxable, potentially clawing back some benefits, and contributions may be restricted to £10,000 annually under the Money Purchase Annual Allowance if a defined contribution pension has already been accessed. The potential tax relief is £1,440 in one year, with higher amounts possible for those who continue earning.
