Increasing numbers of higher-earning workers in the UK are paying more tax at higher marginal tax rates. The Office for Budget Responsibility (OBR) estimates that 2.5 million workers will be drawn into the higher and additional rate bands by 2027/28.¹
Even in retirement, the tax burden is spreading and growing, in a double whammy with the much-elevated cost of living. The OBR recently estimated that in the tax year 2023/24 there are 8.1 million taxpayers of state pension age compared to 6.47 million in 2020/21 - a 25% increase over just three years.
How can I pay less tax in retirement?
With effective retirement planning, people can take a more proactive approach to tax efficiency. Even if you envisage paying the basic rate of tax on your pension income, you can structure your finances so that your retirement assets and income will be less impacted by tax.
It makes sense to use the tax shelters we are all entitled to. By keeping an eye on your tax exemptions and allowances, you can make sure you are making the most of your retirement savings.
How much can a pensioner earn before paying tax?
The total annual amount that anyone in receipt of a personal or workplace pension can receive tax-free from potentially taxable sources in the UK totals £27,227 (as of 2023/24). This amount encompasses income generated from employment, self-employment, pensions, savings interest, dividends and capital gains. It includes, but should not be confused with, the personal tax allowance of £12,570. The personal allowance is the amount you can earn each year without paying tax.
How can tax exemptions and allowances be used?
This tax-free income of £27,227 can be reached by using the following allowances and exemptions in the 2023/24 tax year:
- Personal tax allowance: If you are in receipt of the full state pension of £10,600 per annum, you can also receive a private pension income of £1,970 a year before you reach the personal tax allowance of £12,570
- Pension tax free lump sum (sometimes referred to as a pension commencement lump sum): You can take up to 25% of your pension tax-free. Contrary to popular belief, this does not have to be taken in one go as a lump sum. Alternatively, if you take an income from your pension pot each year, 25% of each withdrawal can be taken tax-free. If you don’t want to pay any tax on your pension income, you could set an annual withdrawal limit of £2,627 (gross). Of this, £1,970 (75%) falls within the personal income tax allowance, while the remaining £657 (25%) is taken from the tax-free element of your pension
- Savings income: The starting rate of tax for savings income (interest) is £5,000, as long as income does not exceed the personal tax allowance of £12,570. The personal savings allowance of £1,000 for basic rate taxpayers means that there is potentially £6,000 in tax-free interest income available
- Investment income and capital gains: If you have an investment portfolio, you can draw income from dividends up to £1,000, and earn up to £6,000 in capital gains without having to pay tax. From 6 April 2024, the dividend allowance will reduce by half to £500, as will the capital gains tax allowance (falling to £3,000)
- Trading: You can earn up to £1,000 tax-free from casual trading, like buying and selling on internet trading sites like eBay, thanks to the trading allowance
Married couples and people in civil partnerships can double most of these tax-free amounts by using both sets of allowances. Also, the transfer of assets between married couples and people in a civil partnership does not trigger tax liabilities.
The importance of pensions and ISAs
Even if you withdraw taxable amounts from your pension, the tax benefits and reliefs on your contributions often outweighs any tax paid. This is commonly the case if you received tax relief on your pension contributions at the higher or additional rate, but then you pay tax at a lower rate when you come to draw a pension income. This usually occurs when someone is a higher or additional rate taxpayer during their working life, but becomes a basic rate one on retirement.
If you pay the same marginal tax rate when you draw on your pension that you paid when you were actively making pension contributions, you will still receive some tax benefits. Tax relief at the top marginal rate applies to the whole of each monthly pension contribution, whereas on drawdown or annuity income the marginal rate applies only to a portion.
ISAs shield investments and cash contained within them from dividend and capital gains tax. As these allowances are set to be reduced further in the next tax year, the importance of ISAs cannot be underestimated.
It’s important to remember that the annual £20,000 ISA allowance is a ‘use it or lose it’ one, and there is no guarantee a future Government will not reduce this. Before the end of each tax year, it is worth considering whether funds – which can be held as cash even in an investment ISA - can be used towards securing this allowance.
ISAs provide a more flexible savings option to personal pensions as you can draw on the money at any age, whereas a pension cannot be accessed until the age of 55 (rising to 57 in 2028). But if they remain untouched into retirement, ISA savings can provide a very useful tax-free supplement to pension income. This could also be useful when trying to keep your pension withdrawals within lower tax bands.
Speak to Evelyn Partners about tax and retirement planning
If you want to know more about how you could pay less tax in retirement, speak to one of our experts. We take the complexities out of tax and retirement planning and help you to achieve your financial goals.
For more information, book a free consultation online or call 020 7189 2400.
¹Office for Budget Responsibility, The impact of frozen or reduced personal tax thresholds, 2023
The value of an investment may go down as well as up and you may get back less than you originally invested.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.
Prevailing tax rates and reliefs depend on individual circumstances and are subject to change