Tax-Efficient Ways to Withdraw from Your Pension

Retirement planning is not just about saving and investing wisely; it’s also about withdrawing your pension efficiently to minimise tax and maximise your retirement income. Many retirees fail to consider tax implications when withdrawing funds, leading to unnecessary tax bills that could have been avoided with careful planning.

In this article, we will explore the most tax-efficient ways to withdraw from your pension in the UK, helping you make the most of your hard-earned savings.

Understanding Pension Withdrawal Rules

In the UK, you can start withdrawing from your pension at age 55 (rising to 57 in 2028). The primary options available for pension withdrawal include:

• Lump Sum Withdrawals
• Flexi-Access Drawdown
• Annuities
• Small Pots and Trivial Commutation
• Defined Benefit Pension Schemes

Each method has tax implications that should be considered before making a decision.

1. Taking Your 25% Tax-Free Lump Sum

One of the key benefits of UK pensions is that 25% of your pension pot can be withdrawn tax-free. However, how you take this amount can impact your future tax liabilities:

• Full Lump Sum at Once: You can take the entire 25% in one go, but the remaining 75% will be subject to Income Tax when withdrawn.
• Phased Withdrawals: You can take smaller tax-free lump sums alongside taxable withdrawals, helping to manage tax efficiency.

Strategy:

Taking your tax-free lump sum gradually instead of in one go can help manage your taxable income, reducing the risk of being pushed into a higher tax bracket.

2. Using Flexi-Access Drawdown

Flexi-access drawdown allows you to keep your pension invested while withdrawing money as needed. You can:

• Withdraw 25% of your pot tax-free.
• Take withdrawals from the remaining 75%, which will be subject to Income Tax.

Strategy:

• Keep withdrawals within the Personal Allowance (£12,570 for 2024/25) to avoid Income Tax.
• Spread withdrawals over several years to remain in a lower tax bracket.
• Use Dividend Allowance (£500 in 2024/25) and Capital Gains Tax Allowance (£3,000 in 2024/25) if you have investments outside your pension.

3. Purchasing an Annuity

An annuity provides a guaranteed income for life or a fixed period. The amount you receive depends on factors such as age, health, and the type of annuity chosen.

Tax Implications:

• Annuity payments are subject to Income Tax.
• No National Insurance contributions are payable.

Strategy:

• Consider a guaranteed period annuity or joint-life annuity if leaving income for a spouse is a priority.

4. Taking Small Pot Lump Sums

If your total pension savings are relatively small, you may be able to withdraw them as lump sums:

• Small Pots Rule: You can withdraw up to £10,000 from up to three personal pensions without triggering the Money Purchase Annual Allowance (MPAA).
• Trivial Commutation: If your total pension savings (excluding the State Pension) are less than £30,000, you may be able to withdraw them as a lump sum.

Tax Implications:

• The first 25% of each withdrawal is tax-free.
• The remaining 75% is subject to Income Tax.

Strategy:

• Consider using the Small Pots Rule instead of taking larger withdrawals from a bigger pension to avoid triggering tax penalties

5. Managing Income Tax When Withdrawing

Pension withdrawals are added to your other income sources for tax purposes, which means planning is crucial to avoid high tax bills.

Tax Bands for 2024/25:

• Personal Allowance (0%): Up to £12,570
• Basic Rate (20%): £12,571 – £50,270
• Higher Rate (40%): £50,271 – £125,140
• Additional Rate (45%): Over £125,140

Strategy:

• Withdraw smaller amounts annually to keep total income below higher tax thresholds.
• Combine pension withdrawals with other tax-efficient income sources (e.g., ISAs).

6. Using ISAs to Supplement Income

ISAs (Individual Savings Accounts) allow tax-free withdrawals, making them an excellent way to supplement pension income while minimising tax.

Strategy:

• Withdraw from ISAs before accessing taxable pension income to stay within lower tax bands.
• If possible, transfer taxable investments into an ISA to benefit from tax-free growth.

7. Deferring Your State Pension

The UK State Pension is taxable, so deferring it can be a useful strategy to manage your tax liabilities.

Benefits:

• For each year deferred, your State Pension increases by 5.8%.

Example:

You get £221.20 a week (the full new State Pension).

By deferring for 52 weeks, you’ll get an extra £12.82 a week (just under 5.8% of £221.20). This will make a new weekly payment of £234.02.

This example assumes there is no annual increase in the State Pension. If there is an annual increase, the amount you could get could be larger.

• You can claim a deferred state pension later when other taxable income is lower (for example you moved to a part-time job)

Strategy:

• If you have other income sources in early retirement, defer your State Pension to increase tax efficiency later on.

8. Taking Advantage of Tax Reliefs and Allowances

Personal Savings Allowance (PSA)

• Basic-rate taxpayers: £1,000 of interest is tax-free.
• Higher-rate taxpayers: £500 of interest is tax-free.

Dividend Allowance

• £500 of dividend income is tax-free.

Capital Gains Tax Allowance

• £3,000 in 2024/25 is tax-free on asset sales.

Strategy:

• Structure withdrawals and investments to maximise these allowances.

9. Avoiding the Money Purchase Annual Allowance (MPAA)

If you take more than the 25% tax-free lump sum as flexible withdrawals, the MPAA may apply, reducing your annual pension contribution allowance from £60,000 to £10,000.

Strategy:

• Avoid large withdrawals unless necessary.
• Consider phased drawdowns to maintain full contribution flexibility.

10. Inheritance Tax (IHT) Planning

Pension funds are not currently subject to Inheritance Tax (IHT), making them an excellent estate planning tool. However, they will become taxable from April 2027.

Tax Implications:

• If you die before age 75, pension funds can be passed to beneficiaries free of income tax. From April 2027, they will be liable for IHT.
• If you die after age 75, beneficiaries pay Income Tax at their marginal rate and from April 2025 also IHT.

Strategy:

• Plan to manage your pension to minimise future IHT liability.
• Gift from unused pension income tax-free using ‘normal expenditure out of income’ IHT exemption.
• Ensure pension nomination forms are up to date to direct benefits efficiently.

Conclusion

Withdrawing your pension in a tax-efficient manner is essential for maximising your retirement income. By utilising strategies such as phased withdrawals, using ISAs, deferring the State Pension, and managing tax allowances, you can reduce your tax burden and stretch your retirement savings further.

Every individual’s circumstances are different, so seeking professional financial advice is crucial to developing a personalised withdrawal strategy that aligns with your goals and minimises tax liabilities.

Need help with pension withdrawals? Contact Glade Financial for tailored retirement planning advice to help you make the most of your pension savings.