How to Avoid Paying Tax on Your Pension 

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Written by: Liez Comendador
How to Avoid Paying Tax on Your Pension

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Since pension income is considered an ordinary income, it is taxed. The rule of thumb is to withdraw only within the annual income tax threshold. Any amount beyond that will incur taxes. However, this is not always the case. Many retirees find themselves paying unnecessary taxes they could have prevented if obtaining pension income was properly planned. 

This article gives a quick guide to the current pension income tax rates and, ultimately, how to avoid paying tax on your pension UK

How Much Tax to Pay on Your Pension

The current income tax threshold is at £12,570, frozen until April 2028. Pension holders do not pay tax when they withdraw within this amount in a year. However, since pension income is added on top of other incomes (e.g., salary, investment earnings, capital gains, etc.), it might end up taxable if the overall annual income exceeds the personal allowance.  

For the current tax year, income tax rates are as follows: 

Annual Income Allowance
Not more than £12,570
Basic Rate
Between £12,571 and £50,270
Higher Rate
Between £50,271 and £125,140
Additional Rate
More than £125,140

Take note that Scotland’s income tax system is different from the rest of the UK. Check out our UK Tax Calculator to determine how much income taxes to pay. For accurate calculations of individual income tax, it is advisable to consult tax professionals. 

Tax experts use the most updated pension tax calculator and guide taxpayers on how to withdraw their pension savings correctly so they do not attract bigger taxes. See below for more information. 

How to Avoid Paying Tax on Your Pension 2024

How to Avoid Paying Tax on Your Pension 

There are many ways to mitigate or even avoid paying tax on pension income. Note that the tax-saving techniques below do not substitute professional tax advice, as every taxpayer’s situation is different. Seeking guidance from tax experts is highly advised to maintain both tax and legal compliance. However, here are what tax experts usually recommend: 

Maximising Annual Personal Allowance 

If pension income, on top of other earnings, does not exceed the personal tax allowance threshold of £12,570, pension holders automatically enjoy tax free benefits. Considering all forms of income is necessary to avoid potentially being pushed into a higher tax bracket. 

For married or civil partners, marriage allowance can be even more maximised. One of the spouses may transfer 10 per cent of their personal tax allowance to the other, given that the latter is a basic rate taxpayer. The partner who transfers allowance must maintain an income of not more than £11,310. This could result in a reduction of the household’s income tax bill annually by £252.  

Not Withdrawing Earlier or at Once 

With defined contribution pensions, employees can withdraw their pension income without waiting for retirement. However, accessing pension money whilst still making contributions triggers the money purchase annual allowance (MPAA). This means reduced tax-free pension allowance from £60,000 to £10,000 and a pension contribution limit of only up to £4,000 in a tax year, ultimately making their pensions less tax efficient. 

Many people get tempted about withdrawing their pension earlier or all at once, but doing so will mean they take up their tax-free entitlement. Once taken, it is irrevocable. Moreover, withdrawing the entire pension at once could lead them to higher tax bills, especially if it pushes their income into higher tax brackets. 

Taking the Tax-Free Lump Sum of 25% 

Pension holders starting from 55 years can typically withdraw up to 25 per cent of their total pension pot without paying taxes, which is their lifetime allowance. For many people, this equals to an average of £1,073,100. In 2028, the eligible age for using the lifetime allowance will rise to 57.  

How to Avoid Paying Tax on Your Pension 2025

Upcoming retirees can withdraw the amount gradually over several tax years if their pension retirement plan allows it, allowing them to optimise tax allowances and minimise unnecessary tax payments. They do not receive a new tax-free entitlement each year. If someone has lifetime allowance protection, they may be able to take a larger tax-free lump sum. 

To take advantage of this available lifetime allowance, retirees must either buy an annuity or enter a drawdown scheme whilst they are taking up the lump sum. This method does not trigger the MPAA, if no extra withdrawals are made from the drawdown account. 

Utilising the Drawdown Scheme 

Whilst the option to access pension funds by buying an annuity has made its comeback given the increasing interest rates, pension holders opt for the more flexible and inflation-proof option, a pension drawdown. The latter allows them to access funds as needed and keep the remaining money invested. It is also exempt from inheritance tax.

Whilst withdrawals from drawdown are subject to income tax, people have better control over the amount withdrawn. If a pension is their only means of income, keeping withdrawals under £12,570 a year can eliminate any potential tax liability. They can also simply adjust withdrawals to avoid higher tax brackets. 

“Withdrawals from drawdown can trigger the MPAA, so it is crucial to consider factors such as tax codes and the potential impact on contributions.”

Drawdown offers the flexibility to adjust income levels year by year to manage tax bills, a feature not available with annuities. However, combining a pension drawdown with an annuity is allowed. This is done by using part of the pension to cover essential expenses through an annuity whilst using the remaining portion for discretionary spending through drawdown.

Withdrawing Only the Needed Amount 

Retirees have endless options on how they may want to spend their golden years. However, no matter how tempting it is to finally be able to splurge, withdrawing only the amount necessary and leaving the rest in their pension plan until needed could be the most prudent choice. By keeping their money invested, there is potential for growth. 

It is important to note that upon retirement, there is no obligation to draw down pension income and place it into savings. In fact, withdrawing more than needed and placing it in a current or low-interest savings account will diminish its value due to inflation. Withdrawing cash to save into a bank account or cash ISA is not the solution if they worry about their investment risk level.  

They may instead consider shifting their pension into lower-risk funds to minimise market fluctuations. Many pension funds automatically adjust investments closer to retirement through “lifestyling.” The latter, however, may not be suitable for those who intend to remain invested for a decade or more beyond retirement. 

Taking a Small Pot Lump Sum of Less Than £10,000 

Those who have smaller pension pots (less than £10,000) from personal pension schemes can take advantage of this option. Whether a pot is partially or totally taxed depends on whether it is crystallised or uncrystallised. Crystallised pensions are totally taxed, whilst uncrystallised pensions leave a tax-free portion of 25 percent.

Individuals have the option to take any pension worth up to £10,000 in one go, and if it is an uncrystallised fund, 25 per cent of the lump sum will be free from tax. They can withdraw up to three small pension pots from both personal and workplace pensions without triggering the MPAA. 

Using ISA Savings to Fund for Initial Retirement 

ISAs typically do not attract taxes if withdrawn within the terms and conditions, which is why many use it for their individual retirement account. They can receive initial retirement funds without affecting their tax-free pension contributions if they are still paying, with the contribution amount capped at £60,000. Using ISA savings can help supplement finances whilst retirees are transitioning from full-time work to reduced hours or full retirement.  

There are some drawbacks, though. For instance, certain ISA types, such as fixed-term cash ISAs, attract interest penalties when withdrawn before their term ends. Lifetime ISAs, on the other hand, allow penalty-free withdrawals after the age of 60 but incur a heavy 25 per cent penalty when savers withdraw before that age.  

Accessing Pension Funds Last

It is wise to tap into pension savings only when the pension holder has used up all ISAs and tax-free pension funds. Delaying the withdrawal of pension income also puts it in a tax withheld status, which means extended longevity of the pension and higher tax-free contributions for those still employed. By deferring claiming, individuals might pay less tax, especially if they anticipate a drop in their income in the future

Passing Pension Pot to Beneficiaries 

Unlike ISAs, pension savings are not considered a part of estate wealth, which means they usually do not attract inheritance tax. If an individual passes away before turning 75, any unused pension funds can be distributed tax-free to their loved ones either as a lump sum or as income, provided it is done within two years.

Frequently Asked Questions

Whilst opting for a pension annuity provides a steady monthly income, choosing a lump sum offers flexibility for various needs, such as covering unforeseen medical costs, providing larger sum in case of early death, and generating passive income over time.

In contract-based pension schemes like personal pensions, individuals have the option to withdraw up to three pension pots, each valued at no more than £10,000, as a small pot lump sum. These small pots are not assessed against the lifetime allowance, potentially lowering the eventual tax liability that might arise. 

Income earned will not impact one’s state pension, but it might influence eligibility for additional benefits, such as housing benefits, pension credits, and council tax reductions. 

In most cases, when someone retires, their employer or pension provider informs HMRC. However, to avoid potential tax errors, it is essential to personally notify HMRC, especially if they are self-employed and nearing retirement. 

How Legend Financial Can Help 

The most effective means on how to avoid paying tax on your pension is planning retirement beforehand. It considers your tax liabilities first thing long before you deal with them. This gives you the upper hand on your taxes, allowing you to use all tax-efficient strategies applicable in your specific circumstance.  

Legend Financial is here to help you approach your pension savings and retirement years in the most tax-efficient way. Consult with our tax professionals today, and we will recommend all the ways you can get the most savings. We have been in the industry for years, so all you need to do is sit back and watch as we streamline and minimise your tax liabilities. Call us today! 


  • Junaid Usman

    Apart from being a partner at Legend Financial, Junaid is an expert on Business Tax including business management advisory services which has proven in the growth of company. He is a promising advisor with an ideology; "Any business success depends on the level of objectivity it maintains."

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Picture of Junaid Usman
Junaid Usman
Apart from being a partner at Legend Financial, Junaid is an expert on Business Tax including business management advisory services which has proven in the growth of company. He is a promising advisor with an ideology; "Any business success depends on the level of objectivity it maintains."

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