No one likes to pay taxes on their income at any stage of life. However, paying taxes is a part of your life, regardless of where you live. Consider taxes as the bills you owe to your government for living where you live, money you earn, roads you drive on, grocery you buy, water you drink, and the list is quite long.

However, when it comes to paying taxes on your pension, which is a type of fund released to you once you have retired, it makes no sense. You have, in all likelihood, already paid taxes on your part of pension funds while you were working, and now you have to do it all again? But just like other taxes, you can’t run from it, can’t hide from it. There's one thing you can do: avoid paying more tax than you should.

Retirement plan encompasses making decisions related to managing the implications of tax on pensions. Understanding the complexities of the UK tax system will help you make informed decisions and reduce your tax liabilities.

This smart guide will help you understand how to avoid paying tax on your pension, make the utmost of your retirement savings, and optimise your spending power in later life.

How Does Tax on Pensions Work?

Tax on pension differs depending on various factors such as pension type, withdrawal amount, and the total income of the taxpayer.

State Pension: This type of pension is taxable but generally paid without deduction of tax. HMRC collects the tax through “Pay as You Earn’ (PAYE) if the total annual income, including your pension, is more than the Personal Allowance. For the year 2023-2024, this implies if the income is over GBP 12,570.

Defined Contribution Pension (Private Pension): Tax is paid on such pension depending on the amount withdrawn. Up to 25% of the amount withdrawn is tax-free, and the balance amount is taxable income.

Tax rates are determined based on the total income, pension, other sources of income, and earnings. The basic tax rate, i.e. 20%, is paid on the taxable earned income, which is more than the personal allowance and if the income is within the basic tax rate band.

If taxable earned income is more than the basic rate limit and personal allowance, you pay a higher tax rate, i.e. 40%.  If the taxable earned income is more than the higher rate band limit, you pay a tax rate of 45% on the income exceeding the limit.

How to Avoid Paying Tax on Your Pension in the UK?

There are many ways that you can adopt to avoid paying tax on your pension. Here are a few tips that work:

1. Comprehending Your Personal Allowances

A personal allowance is the amount of money an individual is allowed to earn every year before they start paying income tax. Presently, the personal allowance is GBP 12,570. Hence, if your income is less than GBP 12,570, you are not liable to pay income tax. Therefore, to reduce or avoid paying tax on your income, ensure that the total taxable non-savings income (including pension) is lesser than the personal allowance amount.

While taking advantage of the personal allowance to save tax, it is best to take the help of accountant services from an expert tax accountant or financial advisor. These experts will assist in customising strategies aligning with your financial circumstances. This will ensure you minimise your tax implications while making the most of your personal allowances.

2. Structure Your Pension Withdrawals Carefully

Under the existing rules, after reaching retirement age, individuals are allowed to take an invested pension pot as cash in one go. The tax that is paid on retirement income applies to only 75% of the total pension amount. This sum is added to the other income in the year it is received, hence pushing you into a higher tax slab.

To avoid paying tax on pension, opt for phased withdrawals instead of a lump-sum withdrawal. You can phase the pension income by gradually taking 25% tax-free pension amount and taxable income. This implies it is more financially beneficial to withdraw a lesser amount or none and be within a low-tax rate slab instead of withdrawing more and having to pay significantly more tax.

3. Deferring the State Pension

It is not necessary that you have to receive your state pension as soon as you are eligible. Although you may forgo your income in the short term by deferring your pension, it makes sense if you are still employed and expect a decrease in income later or in the future. Deferring the pension will help control when you start receiving it. By spreading your taxable income over different years, you can avoid paying tax on your pension because of an abrupt increase in income that will come under the higher tax rate slab.

Moreover, by delaying the state pension, you may be able to take advantage of any unused personal allowance from prior years when you begin receiving it. This will allow you to enjoy a portion of your pension tax-free as long as your overall income stays below the personal allowance threshold.
However, you must keep in mind that deferring pension means receiving a higher amount at a later stage. This, when added to the total income from earnings and other sources, may increase your tax burden at that time. Hence, you need to carefully plan the deferment of your state pension to make sure the increased income does not increase your tax burden.

4. Using ISAs

Stocks and share ISAs (individual saving accounts) are tax-efficient, long-term investments. Income from ISA is tax free, up to GBP 20000 per year. Unlike pensions, ISAs offer the freedom to withdraw money whenever needed without paying tax on the same. Also, your investment grows free from income tax and capital gains tax.

Because of these advantages, ISAs are a great tool for practically any financial purpose. In retirement, they may be especially helpful as a tax-free means to supplement income. They can be used, for instance, to supplement pension income (which is generally taxed after the first 25% of the pot) or, in some cases, to assist in filling a gap until you get a pension.

5. Distribute Assets Efficiently

Income-producing assets can also be divided if you are married or in a civil partnership. These assets can be assigned to the spouse with the lesser income and tax liability or held in joint names.

It is also necessary to think about how you will distribute different asset classes across several accounts. For instance, it is prudent to allocate your ISA allowances to assets that yield dividends instead of cash. In addition, the return on cash is frequently less than that from dividends over the long run.

Some individuals may get higher tax-free interest on their savings (up to GBP 5,000 at the 'starter rate') than they would from dividends. Over time, the interest you receive from cash savings may be less than that of dividends. However, how this works for you might vary depending on how much you make from each, your tax status, and the kinds of investments you make.

How Can Unicorn Accountants Help You?

It's critical to ensure a tax-efficient retirement. For the most savings, use this guide to negotiate the complexity of pension taxation. Make good use of allowances, plan withdrawals, delay state pensions, make use of ISAs, and allocate assets prudently. Make wise choices to reduce taxes, maximise your pension, and guarantee a secure financial future.

As expert tax accountants, Unicorn Accountants is your go-to advisor for all your retirement tax strategies. Our expert accountant services guarantee tax-efficient pension management, from state pension deferment to smart exit planning and allowance optimisation.

Let Unicorn Accountants assist you in negotiating the complex pension tax planning landscape. Call us now, and together, we will create a retirement plan that is both tax-efficient and personalised for you!