Will I pay tax on my pension, and how can I avoid it?

As many get close to retirement, the question arises: Will I pay tax on my pension? In short, yes, in most cases.

However, you can use innovative ways to reduce and sometimes avoid paying unnecessary tax on your pension.

Here, we’ll explain how HMRC taxes pensions and share tips on accessing your pension benefits in the most tax-efficient way.

How does HMRC tax pensions in the UK?

HMRC treats pension income like any other income, so if you're wondering, "will I pay tax on my pension?" the answer is yes, in most cases. As a result, HMRC subjects it to income tax.

The more significant the amount you take out, the more you are likely to crossover into a higher tax band.

However, you do not pay tax on all your income. The UK government gives everyone a personal allowance; this is the amount you can earn each tax year before you are liable for any income tax.

This amount is currently £12,570. So, you won’t pay tax on any amount you earn within this allowance.

We need to pay attention to three more tax bands: the basic, higher, and additional rate bands

The basic rate tax band charges 20% tax on any income earned between £12,571 and £50,270.

The higher rate tax band charges 40% tax on any income earned between £50,271 and £125,140.

Finally, we have the additional rate tax band, HMRC taxes any income above £125,140 at 45%.

Remember, HMRC counts income from your state pension, workplace, and private pensions when calculating how much tax you owe on your pension income.

What about the 25% tax-free lump sum?

You are able to access up to 25% of your pension pot tax-free, but the remaining 75% is where many ask, will I pay tax on my pension withdrawals? and the answer is yes, depending on your income.

You, of course, do not have to take your pension all at once.

Many people opt for a drawdown-style pension to control how and when they access funds, and to minimise the tax on their pension withdrawals.

Doing this gives you more control over when HMRC taxes your withdrawals. Many people will split the withdrawals over multiple tax years to keep tax liability down.

Can I avoid paying tax on my pension?

While it’s difficult to avoid pension tax entirely, many retirees still ask, will I pay tax on my pension if I keep my income low? The answer depends on your total annual income.

Keep your income below the tax threshold

As long as your total income remains below the personal allowance of £12,570, you will not pay any income tax.

Many decide to slowly draw from their pension to stay under this limit.

If you are semi-retired or have other savings, this could work very well for you. 

However, the story changes once you have started to receive your state pension.

The full new state pension amounts to £11,973 a year, which would already make up most of your personal allowance.

Spread withdrawals over several years

Spreading your withdrawals over multiple years can help you stay in a lower tax bracket and reduce how much tax you pay on your pension income.

For example, you need a total of £20,000 from your pension.

By drawing it all at once, you would almost certainly have to pay at least 20% tax on part of it.

However, splitting the withdrawals into two tax years (£10,000 each time) allows you to stay within your tax-free limit on both withdrawals.

Utilise ISA savings first

When you draw money from your ISA, you pay no tax, whereas HMRC may tax your pension depending on your income level. If you have both a pension and an ISA, it may make more sense to draw from your ISA first.

By doing so, you delay drawing your pension and keep your taxable income low.

Delay your state pension

Many people think they must take their state pension when they reach state pension age; this is far from the truth.

If you delay your state pension, the government increases it by 1% for every 9 weeks, not to mention the tax you would avoid paying.

This can be especially useful if you're still earning and want to avoid paying higher tax on your pension by staying under key thresholds.

Phased retirement

Some people decide to work fewer hours and draw part of their pension instead of stopping work all at once.

Doing so allows you to continue earning, ease into retirement, and avoid taking a big tax hit.

When you phase your retirement, you can better manage your finances over the long run.

Pension contributions

When you contribute to your pension while working, you can reduce your tax bill.

If you’re in the higher tax bracket, you could get up to 40% tax relief on your contributions.

 Many people use this strategy to lower their reported income and build up more savings for when they retire.

To summarise, if you're still asking, will I pay tax on my pension? the answer is yes in most cases. However, how much depends on careful planning, timing, and how you manage withdrawals.

By planning ahead, breaking up withdrawals, and using tax-free allowances, we can get the most out of our pensions and make them work smarter for us. 

Get expert advice

It is always worth getting advice from a financial advisor who can tailor things to your situation.

They’ll create a retirement plan that keeps more money in your pocket and leaves less in the taxman’s hands.

Let Regulated Advice match you with a financial advisor for expert advice.