TAXING TIMES
How to legally avoid paying tax on your pension as millions hit with shock bills
Read on to find out how you can reduce your tax bill
MILLIONS of retirees have been hit with shock tax bills after their state pension payments increased.
Around 904,000 people on the state pension are now paying income tax at 40%, according to data obtained from HM Revenue and Customs in a freedom of information request.
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Meanwhile, 124,000 retirees are now paying the tax at an eye-watering 45%.
The new state pension rose to £11,973 a year in April, putting it within touching distance of the £12,570 income tax threshold.
But some pensioners receive more than this amount each year because they delayed the date at which they started to claim the payments.
Pensioners who get income from a private pension could also find themselves pushed over this threshold.
Read more on the state pension
Income tax thresholds are frozen until April 2028, which means that more people could find themselves dragged into higher tax bands through a concept called fiscal drag.
The higher rate tax band is frozen at £50,270, which means any earnings over this amount are taxed at 40%.
Meanwhile, the additional rate tax band is fixed at £125,140, beyond which any earnings are taxed at 45%.
But there are things you can do to stop a surprise tax bill landing on your doorstep.
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Here we explain how you can avoid the tax trap.
Time your tax free withdrawals
You can withdraw up to 25% of your pension pot tax free when you first retire.
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However, you need to pay tax on any money you withdraw beyond this.
Any money you withdraw is added to the other income you receive, which could push you into a higher tax bracket.
One way to avoid this is to spread out your withdrawals over several years, suggests Andrew Oxlade, investment director at Fidelity International.
He said: “If you do take a portion of the 25% tax-free sum every year, that income, along with income from Isas and your state pension, could be enough to keep taxable withdrawals from your pension below the higher-rate threshold.”
How does the state pension work?
AT the moment the current state pension is paid to both men and women from age 66 - but it's due to rise to 67 by 2028 and 68 by 2046.
The state pension is a recurring payment from the government most Brits start getting when they reach State Pension age.
But not everyone gets the same amount, and you are awarded depending on your National Insurance record.
For most pensioners, it forms only part of their retirement income, as they could have other pots from a workplace pension, earning and savings.
The new state pension is based on people's National Insurance records.
Workers must have 35 qualifying years of National Insurance to get the maximum amount of the new state pension.
You earn National Insurance qualifying years through work, or by getting credits, for instance when you are looking after children and claiming child benefit.
If you have gaps, you can top up your record by paying in voluntary National Insurance contributions.
To get the old, full basic state pension, you will need 30 years of contributions or credits.
You will need at least 10 years on your NI record to get any state pension.
He adds that this could be a particularly good idea for people who do not have a particular use in mind for their tax-free sum, such as paying off their mortgage.
Andrew recommends that you add up your income from other sources and take the exact amount that will keep your total income below the tax threshold.
Avoid emergency tax
Once you have withdrawn the tax-free portion of your pension pot you will need to pay tax on any money you take out.
When this happens, many savers are put on an emergency tax code.
This happens because HMRC does not have an up to date tax code for you, so as a default it charges a higher estimated rate.
You may then receive an unexpected tax bill and it can take months to get the money back.
One way to avoid this is to take just £1 from your pension pot, which will trigger a tax code from HMRC.
What are the different types of pensions?
WE round-up the main types of pension and how they differ:
- Personal pension or self-invested personal pension (SIPP) - This is probably the most flexible type of pension as you can choose your own provider and how much you invest.
- Workplace pension - The Government has made it compulsory for employers to automatically enrol you in your workplace pension unless you opt out.
These so-called defined contribution (DC) pensions are usually chosen by your employer and you won't be able to change it. Minimum contributions are 8%, with employees paying 5% (1% in tax relief) and employers contributing 3%. - Final salary pension - This is also a workplace pension but here, what you get in retirement is decided based on your salary, and you'll be paid a set amount each year upon retiring. It's often referred to as a gold-plated pension or a defined benefit (DB) pension. But they're not typically offered by employers anymore.
- New state pension - This is what the state pays to those who reach state pension age after April 6 2016. The maximum payout is £203.85 a week and you'll need 35 years of National Insurance contributions to get this. You also need at least ten years' worth to qualify for anything at all.
- Basic state pension - If you reach the state pension age on or before April 2016, you'll get the basic state pension. The full amount is £156.20 per week and you'll need 30 years of National Insurance contributions to get this. If you have the basic state pension you may also get a top-up from what's known as the additional or second state pension. Those who have built up National Insurance contributions under both the basic and new state pensions will get a combination of both schemes.
Once you have the code you can withdraw money from your pot and will be charged at the correct rate.
Check your pension provider’s rules to make sure it will allow you to withdraw such a small sum of money.
Use your Isa
Isas are a great way to top up your income without paying any tax.
This is because all money you withdraw from an Isa is tax-free, so it does not count towards your taxable income.
To make use of them just make sure you withdraw less than £50,271 from your private pension.
You can then top up your income with money from an Isa.
Or if you do not want to pay any tax then simply claim your state pension and withdraw any extra money you need from your Isa.
Pay into your pot
If you are still working when you start to receive the state pension then you will be able to benefit from a tax loophole.
This is because you can still pay into your private pension even if you are above the state pension age, which is currently 66.
Robert Cochran, retirement expert at Scottish Widows, explains: “This can be especially beneficial if your pension income pushes you into a higher tax bracket.
“Contributions may reduce your taxable income and bring you back into a lower band.”
The maximum amount that you can pay into your pension once you are above the state pension age is £10,000.
This can have a significant impact on the tax you need to pay.
For example, if you earned £10,000 from your job and received the full new state pension then your total income would be £21,973 a year.
In total, you would pay £1,878.80 in income tax.
But if you paid the money from your job into your private pension then you would not pay any tax.
Make use of marriage allowance
You may also be able to save on your tax bill if you are married or in a civil partnership.
Depending on how much you earn, you may be able to transfer some of your personal allowance to your partner.
This tax perk is called marriage tax allowance.
You can transfer up to £1,260 of your personal allowance to your husband, wife or civil partner.
Doing so reduces your tax bill by up to £252 a year.
To benefit you need to be earning less than your personal allowance, which is £12,570.
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Meanwhile, your partner must earn less than £50,270.
You can check if you will benefit from marriage tax allowance using the calculator on the website.
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