Everything you need to know about tax in retirement

Adrian Howard
June 22, 2022

As tax year-end approaches, it’s important for owners of small businesses to make sure they’re making the most of their allowances. We look at some strategies that will help.

  • There’s much greater flexibility when it comes to retirement incomes these days, but there are also a few traps waiting for the unwary.
  • Our tax situation can suddenly be very different in retirement, with new choices to be made and costly mistakes to avoid.
  • An adviser can point you in the right direction and ensure you take your retirement income in the most tax-efficient way.

It used to be that when you reached retirement, your journey as a pension investor effectively ended. That’s no longer the case, thanks to the 2015 reforms to Defined Contribution (DC) pensions, which have resulted in many people remaining invested during retirement. The process is now much more seamless, and in some cases very little really changes.

But some things do change, and it’s important to be aware of them. Perhaps the most obvious is the way in which you’re taxed once you begin to take an income in retirement. While there are more opportunities for tax-efficiency these days, there are also a few more pitfalls that need to be avoided.

A new tax regime

During your working life you generally didn’t have to think too much about which income would be taxed, because it would usually be your earnings. And you may well be aware that while you can still be charged Income Tax in retirement, you’ll no longer have to pay National Insurance contributions after hitting State Pension age.

But the tax situation is suddenly quite different in other ways too, notes Tony Clark, Senior Propositions Manager at St. James's Place. “From a tax perspective, you can now control much more about how you take your income and how much tax you pay,” he explains. “You could well have pensions, Cash ISAs, Stocks & Shares ISAs, property, earnings and so on. But how you extract money from that, and use it as income, is treated and taxed differently.”

The best course of action won’t always be obvious. For many of those who are deciding where to take an income from once they’ve retired, the starting point will be their pension – but while the first quarter of your DC pension pot can be taken tax-free, people often forget that anything above that 25% will be taxed at your marginal rate. In other words, the way the pension is taxed makes it worth exploring other options.

For example, income from your ISA won’t be taxed, giving you flexibility to take your income from one place and not another, or to have a mix. “A lot of people don’t necessarily realise this,” says Clark. “They’ll rely heavily on a pension income that’s taxed, perhaps because they’re not aware of other ways of doing it. This is where an adviser can step in and help you, simply by knowing which levers to pull.”

Navigating an unfamiliar landscape

There are several other tax-related pitfalls to be aware of in retirement. Since the reforms of 2015, a number of people have fallen into the trap of taking a lump sum from their pension pot (beyond the tax free cash lump sum) without realising it would be treated as income, resulting in them having to pay ‘emergency tax’ and potentially receiving less money than anticipated, or with a tax headache.

“This is purely because HM Revenue & Customs (HMRC) looks at any extraction of the capital beyond the tax-free cash as being used for income,” Clark explains.“Even if you take a £10,000 lump sum, they’ll see it as income of £10,000 and they’ll tax you accordingly. So you need to be on top of your HMRC account and ensure it’s set up correctly so they know it’s a one-off and not a regular withdrawal you’re making.”

Similarly, taking a lump sum from a pension pot could risk pushing you into a higher tax bracket, particularly if you’re a basic-rate taxpayer just below the higher-rate threshold. Again, this is because the lump sum is treated by HMRC as income.

“However, you could use the different tax years to your advantage here,” says Clark. “For example, if you take £5,000 in one tax year and £5,000 in the following tax year, you might be able to stay under the higher-rate threshold.”

Steering clear of the traps

There’s one failsafe way to ensure you don’t end up paying more tax in retirement than you need to – get pension advice from someone who knows the costly mistakes to avoid.

“When you’re approaching retirement, you should speak to an adviser to ensure you’re taking income in the most tax-efficient ways, because it is quite different from how you’re taxed when you’re working,” says Clark.

This applies to anyone leading up to and entering retirement. And it can be especially pertinent for those reaching retirement with both DC and Defined Benefit (DB, or final salary) pension pots. That’s because the income from a DB pension will be paid to you whether you want it or not, and it will be taxed. So, it’s important to know which incomes you’re going to get anyway and which incomes you have more flexibility with.

“An adviser can help you see the bigger picture and understand which of your assets are subject to which tax regime when you take money out,” says Clark. “It’s a time of life when a lot of people want to take lump sums, and there are important decisions to make, so you don’t want to take your eye off the ball at the last minute.”

The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.

The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.