While pensions offer a tax-efficient way to save for your retirement, care needs to be taken when you access them. While pensions offer tax advantages while you’re building them, they can be subject to potentially significant tax charges when you draw money from them.
Paying too much tax when you access your pension could reduce the level of income you’re able to take from it, which in turn could reduce your retirement lifestyle. Worse still, overpaying tax could mean you inadvertently deplete your pension pot early, which could put your long-term financial security at risk.
Read on to discover three common ‘tax traps’ and why working with a financial adviser could help you sidestep an unexpected tax charge.
Your retirement income may be more exposed to Income Tax
An article by This is Money in June 2023 makes for interesting reading. It revealed that the amount of pensioners paying Income Tax increased by 25% in 2022/23 when compared to the previous tax year.
Furthermore, 41% more pensioners are now paying higher-rate tax after former chancellor Jeremy Hunt froze Income Tax thresholds until April 2028. As a result, you may become liable to 20% basic-rate Income Tax if you earn more than £12,570 a year, or the 40% higher-rate tax band if you earn £50,271 or more a year.
This is why it’s more important than ever to consider how you’re drawing your pension income, and whether you can do so in a more tax-efficient way. For example, you might want to consider drawing a smaller income and using your tax-free lump sum to boost your earnings.
Doing this may allow you to drop down to the 20% basic rate of Income Tax from the 40% higher-rate. A financial planner can help you understand the most tax-efficient way you can withdraw your pension income, which could help you to enjoy peace of mind and a better standard of living.
Your ‘tax-free’ lump sum may also become liable to Income Tax
In April 2024 the Lifetime Allowance (LTA) was abolished. The allowance was the total amount you could build up in your pension without incurring a tax charge.
While broadly this means that you can have any amount in your pension in 2024/25 and not be liable to an LTA tax charge, there are caveats. One of these caveats is the lump sum allowance, which this limits the amount of tax-free cash you’re allowed to take from your pension.
If you breach the limit, which in 2024/25 is £268,275, the amount you take that’s above the threshold could become liable to an Income Tax charge at your marginal rate. As you can see, this could result in an unexpected and potentially substantial tax charge.
If you have successfully applied to HMRC for lifetime allowance protection, your lump sum allowance may be higher. This is something a financial adviser will be able to confirm for you.
You may pay ‘emergency tax’ rates when you first access your pension
According to Which?, figures from HM Revenue & Customs (HMRC) reveal that thousands of pensioners were refunded a total of £57 million between 1 April and 30 June 2024. This is because the way they took their first payment from their pension pot resulted in them being charged too much Income Tax.
While the over payment can be claimed back, it can take several months to receive it from HMRC. The reason for the over payment is that many pensioners take a larger amount from their pension the first time they access it, which they may then use to pay for a ‘holiday of a lifetime’, work done on their home or a new car, for example.
However, HMRC will assume that this is the amount that will be taken every month, and so, will tax accordingly. As such, if you take £10,000 out of your pension when you access it, HMRC will calculate your Income Tax as though you will be drawing £120,000 a year.
Furthermore, if your pension provider does not know your tax code, you will be taxed using a higher-rate emergency tax code. This too could mean your Income Tax liability is significantly higher than it should be, meaning you will need to reclaim the over payment from HMRC.
Helping clients to access their pension in the most tax-efficient way is something financial advisers are well versed in. As such, working with an adviser can help to ensure you do not pay too much tax when you first access your retirement fund, meaning you then don’t have the headache of having to reclaim it from HMRC.
Get in touch
If you are approaching retirement and would like to sidestep these common taxation trap doors, please contact us. We can ensure that you access your pension pot in the most tax-efficient way possible, which in turn, could help to boost the amount of income you can take from your pension.
Furthermore, a financial adviser can ensure you’re taking the right levels of income, meaning you’re unlikely to inadvertently deplete your pension pot too early. Doing this could result in you having to significantly reduce your standard of living later on in life.
Thursday 12 September 2024