14 March 2023
As you approach retirement, you may already be aware that your tax situation will change.
Whether you plan to continue working part-time in later life or retire completely, as soon as you draw your pension you will likely pay tax differently than you have been throughout your career.
An important thing to remember is that although you are not yet retired, preparing as early as possible for a pension withdrawal is essential to mitigate unnecessary tax bills.
Shockingly, figures published by MoneyAge reveal HMRC repaid £134 million in overpaid pension tax in 2022 alone. What’s more, Just Group reports that 53% of people who took their pension in 2021/22 were “DIY dippers” – meaning they had not taken advice beforehand. As a result, many fell into often-overlooked pension tax traps.
So, here are four pension tax traps retirees often overlook, and how to avoid falling into them.
1. Inadvertently overpaying tax on your first pension withdrawal
Unfortunately, despite the introduction of Pension Freedoms legislation in 2015, which allows individuals to flexibly access their personal pension at 55 (rising to 57 in 2028), there are still often taxation issues the first time someone draws their pension.
Indeed, the MoneyAge report shows that, when an individual first accesses their pension, they could be placed on an emergency “month one” tax code. This may cause their initial withdrawal tax bill to be much higher than necessary – this is why HMRC paid £134 million in rebates last year alone.
While there may be nothing you can do about this at present, it is crucial to ensure you check how your first pension withdrawal has been taxed, and apply for a rebate if you are eligible.
Sadly, some individuals may not have realised they were overtaxed, and could lose out on valuable retirement income from the outset. So, speaking with your financial planner when you first draw from your pension could be beneficial; you could receive thousands if you are owed a rebate from HMRC.
2. Taking your entire pension as a lump sum
While you are free to take your personal pension however you like, drawing the entire fund as a lump sum could mean you fall into an expensive tax trap.
Indeed, there may be reasons you wish to take all your pension wealth at once, including having full control of the sum from day one.
However, you can only usually take 25% of your pension at once without incurring a tax bill. The remaining 75% of your pension savings would then be taxed at your marginal rate of Income Tax – meaning you could pay up to 45% of that sum straight to HMRC.
Instead, flexibly accessing your pension, and taking smaller amounts each time you withdraw, could be a much more tax-efficient way to receive your later-life income.
Remember: your personal circumstances are unique. Before taking any money from your pension, it could be wise to consult a financial planner for guidance.
3. Exceeding the Lifetime Allowance
One often-overlooked pension allowance that could incur a weighty tax bill is the Lifetime Allowance (LTA).
Previously fixed at £1,073,100 until 2026 by former chancellor Rishi Sunak, the LTA marks how much you can contribute into a pension in your lifetime. However, in his spring Budget, chancellor Jeremy Hunt announced that, from 6 April 2023, “the government will remove the Lifetime Allowance charge, before completely abolishing it in a future Finance Bill”.
If your pension(s) do exceed the threshold and you plan to draw the funds before the end of the 2022/23 tax year, you could be taxed at the following rates when you withdraw:
- 55% on funds drawn as a lump sum
- 25% on funds drawn as income. This will be on top of your marginal rate of Income Tax.
Fortunately, the LTA tax charge will no longer be applied to pensions drawn after 6 April 2023 – and as you read earlier, the Conservatives plan to fully abolish the LTA in future.
So, if you do plan to draw your pension soon, it could be wise to wait until the LTA charge is removed. That way, you could benefit from a more tax-efficient pension withdrawal from the start of the 2023/24 tax year onwards.
4. Triggering the Money Purchase Annual Allowance
Finally, the fourth tax trap future retirees should be aware of is the Money Purchase Annual Allowance (MPAA).
As of the 2022/23 tax year, the Annual Allowance, which is the amount you can contribute into a personal pension each year and still receive tax relief, is £40,000 or 100% of your total earnings, whichever is lower.
If you choose to flexibly access your pension at 55 or over (rising to 57 in 2028), you might wish to keep contributing back into your pension after you draw it – for example, if you are still working part-time.
However, by choosing flexi-access, you trigger the MPAA, which reduces the amount you can pay into your pension tax-efficiently from £40,000 to £4,000 a year.
Importantly, in his spring Budget, the chancellor announced that from 6 April 2023:
- The Annual Allowance will increase to £60,000
- The MPAA will stand at £10,000.
In either case, while flexi-access can help mitigate an Income Tax bill, it is important to remember that the amount you can re-contribute while still receiving tax relief is strictly limited.
It could be wise to discuss your retirement plan with your financial planner ahead of time, so you are fully prepared for these changes in your tax situation.
Get in touch
Want to discuss your future retirement and avoid these tax traps where possible? Get in touch. Email firstname.lastname@example.org or call 0161 8080200.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
All contents are based on our understanding of HMRC legislation, which is subject to change.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.