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Six ways to pay less tax in retirement

A potential tax danger is lurking for many pensioners as the state pension increases and income tax bands remain frozen. Here's how to ensure you aren’t paying too much tax in retirement.

| 10 min read

Pensioners are in line to receive another hefty boost to their income this year. The state pension will increase by 8.5% in April 2024, having increased by 10.1% in April 2023.

This is in accordance with the government’s ‘triple lock’, which specifies the benefit goes up in line with wage growth, inflation or 2.5% – whichever is higher. It takes a full new state pension from £10,600 in the 2023/24 tax year to £11,502 in 2024/25.

As the state pension rises a potential tax danger is lurking for many pensioners. The income tax personal allowance, the tax-free slice of your overall income, is currently frozen at £12,570 a year, which could mean many people receive less income from other sources tax free. This could result, for instance, in a tax code change on a pension or annuity, or it may mean having to report other income to HMRC for the first time.

Is the state pension taxable?

The state pension is taxable, but if it’s your only income you won't pay any tax on it as it falls within the personal allowance. However, if you have income from other sources, you’ll pay tax on any income that exceeds it, and because the allowance is frozen until at least April 2028 it could soon be used up by a full state pension entitlement unless something changes.

For instance, two further 5% increases to the state pension on top of an assumed 8.5% next year would see the full state entitlement go above the personal allowance in the 26/27 tax year. But even before that becomes an issue, many pensioners will need to keep a close eye on their financial affairs to ensure they don’t trigger an unexpected tax liability.

Do you pay tax on retirement income?

If your income in retirement exceeds the personal allowance you will start to pay tax, initially at ‘basic rate’, which is 20% for earnings or pension income, as well as other sources such as rental income from property and savings interest. The rate is less for dividends from shares at 8.75%.

The basic rate band for 2024/25 is £37,700, which means, broadly speaking, you pay ‘basic rate’ tax on income between the personal allowance and up to £50,270. After this, ‘higher rate’ tax of 40% is payable on the slice above and then the ‘additional rate’ of 45% over £125,140. This is broadly how income tax works in the UK, but please note if you are a Scottish taxpayer the rates and bands are different. Follow the link if you’d like to find out more about the UK tax brackets.

Fortunately, there are ways to help you reduce the amount of income tax you pay in retirement and they could in some circumstances make the difference between having to pay tax or not, or being able to stay within one of the income tax bands. Here’s some tips to get you started, but remember this is not personal advice and if you are any doubt about how this information applies to you then you should contact a tax professional.

Six ways to pay less tax in retirement

1. Understand your allowances

There are certain ‘allowances’ for a limited amount of savings and dividend income, which helps you earn modest sums from your cash and shares without paying tax.

Separate to the income tax personal allowance, the personal savings allowance allows basic rate taxpayers to earn £1,000 of interest in 2024/25 before paying tax, while higher rate taxpayers have a lower allowance of £500. Additional rate taxpayers don’t receive any personal savings allowance.

There is also an extra ‘starting rate’ for savings, which is a special 0% rate of income tax for savings income of up to £5,000 for those with total taxable income below £17,570 in 2024/25.

Meanwhile, the dividend allowance allows investors to receive £500 tax free from shares for the 2024/25 tax year, having been reduced from £1,000 in the previous tax year and £2,000 the year before that. You can find out more on the subject by checking out my article on the UK dividend tax rates.

2. Maintain your tax efficient savings

There are various ways to shelter your savings from tax. One is to use a Cash ISA as any interest is completely tax free. However, the more you use your £20,000 a year ISA allowance for cash the less you’ll have available for investments in a Stocks & Shares ISA, which may ultimately prove more useful in terms of avoiding tax on income or gains from shares or other assets.

National Savings and Investments (NS&I) also offers certain tax-free cash savings products, notably Premium Bonds where your money is secure and you are entered into a monthly prize draw where you can win between £25 and £1 million tax free.

3. Structure withdrawals from pensions carefully

Under current rules, once you reach normal retirement age you can normally take an invested pension pot such as a SIPP as cash in one go. However, the taxes you pay on retirement income will generally apply to 75% of this sum and is added to other income in the tax year it is received, so it could push you into a higher income tax band.

You can ‘phase’ your pension income in retirement by taking both the 25% tax-free lump sum and taxable income in stages. Spreading withdrawals over multiple tax years in this way can mean you make the most of tax allowances and avoid paying more tax than necessary.

How does a SIPP work?

4. Use ISAs for tax-free income

Stocks and Shares ISAs are a tax-efficient way to invest your money for the long-term. Unlike a pension, an ISA also offers the freedom to withdraw money simply and easily whenever you want to without paying any tax. Your money also grows free from income tax and capital gains tax.

These features makes ISAs very useful for almost any investing need, and for retirement they can be particularly useful as a way to supplement income without any tax consequences. For instance, they can be used as a complement to pension income, which is usually taxable beyond the first 25% of the pot, or in some circumstances to help bridge a gap until you access a pension.

5. Consider deferring the State Pension

Not everyone realises you don't have to receive your state pension as soon as you're entitled. In fact, if you don't take action to claim your state pension, it'll be automatically deferred. By not claiming your state pension right away you're forgoing income in the short term, but if you are still working and you know you’ll experience a drop in income later on it can make sense. You might pay less tax on your pension, plus you’ll get a larger amount when you choose to take it.

However, you must also be confident you will live a relatively long life. The longer you live the more valuable deferring gets, but if you live for significantly shorter than average it is unlikely to be worth it. Follow the link to get more information on deferring the State Pension.

6. Distribute assets efficiently

If you are married or in a civil partnership, you can also consider splitting income-producing assets, either by holding them in joint names or allocating them to the partner with the lower income and tax liability.

You can also consider how you arrange your asset types across different account. For instance, it can make sense to prioritise your ISA allowances for dividend-producing investments rather than cash. For some individuals, the personal savings allowance applied to interest on cash is significantly higher than the dividend allowance, at up to £5,000 for the ‘starter rate’, and the return on cash is often lower than that from dividends in the longer term. However, the situation will depend on tax position, the mix of assets you own and how much you get paid in interest on cash.

Seek retirement advice or guidance if you are unsure

This article only scratches the surface and there are many multiple factors to consider when looking at your income and the tax you pay in retirement. Yet with some careful planning you can secure your financial future. You also don’t have to tackle it on your own. Having a conversation with a financial professional can help you to take control of your finances, giving you freedom and peace of mind.

To get you started our OneStep Financial Coaching allows offers an educational session based on the topic of your choice so you can get the most out of it. We offer a free, no commitment, 15-minute call with a qualified professional to discuss your needs, and after that each one-hour coaching session is charged at a one-off fee of £150 (including VAT).

Importantly, all our financial coaching is provided by regulated and qualified financial planners who work for Charles Stanley, a regulated company. Not only will you benefit from more formal experience and qualifications, but if your financial coach believes you would benefit from more comprehensive guidance, or even full financial advice, they will refer you to an advisory service.

Find out more

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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Speak to a real-life financial planner, who can help you gain clarity around your money situation and take the next steps with confidence.

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The tax treatment of pensions depends on individual circumstances and may be subject to change in future. It is always recommended that you seek advice from a suitably qualified investment professional if you have any doubt as to the suitability of a pension and/or the underlying investments. You should be aware that Stakeholder Pension Schemes are generally available and might meet your needs as well as a SIPP. Please remember the value of investments may fall as well as rise and your capital is at risk.

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