Tax is the one thing none of us enjoys, and as you approach retirement you may well find yourself wondering how to avoid paying tax on your pension. You cannot avoid it entirely, but with a bit of planning you can often legitimately reduce how much you pay, keeping more of your money for you and your family. This guide explains how pensions are taxed and the practical, legitimate ways to lower the bill.
How is your pension taxed?
When you take money from your pension it is taxed much like income, through PAYE, though you do not pay National Insurance on it. The key features to understand:
- You can normally take up to 25% of your pension tax-free, up to the Lump Sum Allowance of £268,275 for most people (this can vary with how you withdraw and any protections you hold).
- Beyond your tax-free cash, withdrawals count as income, and you pay no tax on income up to your personal allowance (currently £12,570 a year).
- Your 25% tax-free entitlement does not have to be taken in one go, if your policy allows, you can take it in stages.
Pension drawdown tax: the bands
Pension income is generally taxed in the same way as employment income. You normally get a tax-free Personal Allowance of £12,570, although this is reduced by £1 for every £2 of income above £100,000. This means that income between £100,000 and £125,140 can be subject to an effective marginal tax rate of 60% for taxpayers paying the 40% rate. Above £125,140, the Personal Allowance is fully withdrawn and the 45% additional rate applies.
The State Pension is taxable too, although on its own it will usually fall within the Personal Allowance. The practical lesson for pension drawdown is that taking a large withdrawal in a single tax year can push you into a higher tax band or, depending on your income, into the Personal Allowance taper. How much you take, and when you take it, therefore requires careful consideration.
How to legitimately reduce the tax you pay
You cannot pay no tax without living on a very low income, but you can avoid paying more than you need to:
- Don’t take more than you need. Once you cross into a higher band, the extra is taxed at the higher rate, so keeping withdrawals within the basic-rate band where possible saves tax.
- Don’t take your whole pension at once. Spreading withdrawals across several tax years lets you use each year’s allowances, rather than triggering a large one-off tax bill.
- Phase your tax-free cash. If your policy allows, taking your 25% tax-free entitlement gradually can top up your income and keep you under a tax threshold.
- Use your other allowances. Drawing on ISAs (tax-free) alongside pension income, and using a spouse’s personal allowance, can reduce the household’s overall tax, a core part of how to reduce tax in retirement.
A note on passing your pension on
The tax treatment of pensions on death is changing: from April 2027, most unused pension funds are expected to fall within your estate for Inheritance Tax. That makes it worth looking at how you draw your pension and how you plan your estate together, rather than in isolation. Because this area is changing, confirm the current rules before acting.