Your pension is likely to be a cornerstone of your retirement plan. Yet, withdrawals can trigger significant income tax bills if you’re not careful.
Income tax bands have now been frozen until 2031, and more pensioners are entering higher tax brackets. As such, minimising this liability has never been more critical.
Here, our financial planners at Castlegate outline five practical strategies to help you keep more of your hard-earned pension pot.
UK pension rules allow 25% of your defined contribution (DC) pension to be withdrawn tax-free, up to a standard lump sum allowance of £268,275 for the 2025-26 tax year.
The remaining 75% is taxed as income at your marginal rate: 20% basic (up to £50,270), 40% higher (£50,271-£125,140), or 45% additional rate.
Your Personal Allowance stands at £12,570 tax-free, but frozen thresholds mean more income is pushed into taxable bands as your pay goes up.
One key rule to be aware of is the Money Purchase Annual Allowance (MPAA). Once it kicks in, this limits new contributions to £10,000 per year. For instance, this happens when you access taxable income via flexi-drawdown or uncrystallised funds pension lump sums (UFPLS).
One idea is to take your full 25% tax-free cash early to create a tax-free pot for later use, preserving taxable funds for when needed.
For example, a £400,000 pension yields £100,000 tax-free. This could then be invested over time in a Stocks & Shares ISA, growing without further tax drag.
Be mindful of tapered allowances if your income exceeds the £260,000 adjusted threshold, reducing your annual allowance. Couples can coordinate: one partner takes tax-free cash while the other defers, optimising household tax.
Another option is to only withdraw enough pension income to utilise your £12,570 Personal Allowance and stay below the £50,270 basic rate threshold.
This could be achieved using “phased drawdown” (taking smaller amounts - e.g. annually). For instance, £40,000 yearly withdrawal - on top of a full new State Pension - keeps most of your income taxed at 20%.
Tools like drawdown calculators can reveal optimal sequences, potentially saving £10,000+ in tax over a decade for a £300,000 pot. However, for the best results and complete peace of mind, it helps to consult a financial adviser.
Pensions are not the only item in your tax planning toolkit. If you can supplement pension income with tax-free ISA withdrawals (£20,000 annual allowance), this can be a powerful way to avoid needless taxable withdrawals.
ISAs offer 100% tax-free growth and access, ideal for bridging gaps without breaching bands. For instance, a £200,000 ISA could bestow you with £12,000/year, tax-free, over 16 years (this is setting aside any growth within the ISA from interest etc.).
Also, explore whether you could employ savings allowances (£1,000 basic-rate interest tax-free) and your £3,000 CGT exemption for non-pension assets.
When it comes to taking a pension income, many people are attracted to flexi-access drawdown due to the control it offers.
For example, someone might draw a tax-free lump sum first, then taxable income as needed, keeping remaining funds invested.
This 'four-box' strategy (not necessarily to be taken in order):
Can be a good way to optimise sequencing - leaving high-growth assets untouched while living off tax-free/savings.
Speak with an adviser about how to maximise tax relief before crystallising. For instance, by contributing up to £60,000 annually (if your income allows), this can offer 20-45% upfront relief.
Salary sacrifice also saves on National Insurance (up to a £2,000 cap post-2029), making it ideal for employed individuals nearing retirement.
Employer contributions face no MPAA limit, so explore whether you could negotiate matches. Also, take a look at any unused annual allowances from the past three years. This could unlock up to £160,000 in allowance for your pension contributions.
Here at Castlegate, clients approaching or in retirement often uncover overlooked efficiencies through tailored strategies. Mapping your pension alongside ISAs, property and other assets can reveal some amazing opportunities to shield more from unnecessary tax.
Please note that pension tax planning requires a personalised lens as rules evolve (such as the 2031 threshold extension). Individual circumstances also vary. By conducting regular reviews, you can ensure alignment with goals, adapting to changes while balancing growth and liquidity.
If you'd like a no-obligation review to limit tax on your pension and secure your retirement income, please get in touch.
Your capital is at risk. Investments can go down as well as up, and you may not get back the amount you originally invested. Past performance is not indicative of future results. Diversification does not guarantee profits or fully protect against losses. Tax treatment depends on individual circumstances and may change in the future. This content is for information only and does not constitute personal financial advice. Readers should seek independent financial advice before making any investment decisions.
Castlegate Financial Management Limited is registered in England No. 2077374. Registered Office: 8 Castlegate, Grantham, Lincolnshire. NG31 6SE. Authorised and Regulated by the Financial Conduct Authority. FCA No. 169777.
