Paying too much tax in retirement is a common pitfall and one that could be easily avoided with a little bit of know-how and the right plans in place. We take a closer look at what the latest change means for those claiming the state pension and other ways to ensure you don’t pay too much tax in retirement.

Gap between state pension and personal allowance narrows

The 8.5% increase is thanks to the triple lock, a policy that has been subject to constant scrutiny, with critics flagging concerns about its sustainability. The triple lock guarantees the state pension rises every year by whatever is highest – inflation, average wage increase or 2.5%. And while this bumper increase has been warmly welcomed by pensioners, especially those on the lowest incomes, there is another factor at play that will temper its impact.

The decision to freeze income tax thresholds at their current levels until 2028 means the gap between the state pension and the personal allowance – or to put it simply, the amount you can earn before paying tax – is narrowing significantly.

Given that the personal allowance is set to remain at £12,570 until 2028-29, even a few years of moderate increases will see the state pension tip into tax-paying territory. This could mean that pensioners will pay tax on all income they receive outside certain tax wrappers such as an ISA and any interest above the £1,000 personal savings allowance. What's more, analysis by the House of Commons for the Liberal Democrats calculates that an extra 1.6 million pensioners will pay tax in the next four years.

Here's what you can do to keep your tax bill as small as possible:

Pay your state pension into a personal pension if you’re under 75

It may feel counterintuitive to even think about putting your state pension into a personal pension or self-invested personal pension (SIPP). After all, it’s paid as a retirement income, and for many older people it forms the backbone of their retirement finances. But if your state pension starts tipping into tax-paying territory – an increasing likelihood due to these latest changes – then channelling the cash into a pension wrapper makes a lot of sense from a tax perspective. You’ll benefit from tax relief and you may be able to build up further tax-free cash entitlement.

Access your money in the most tax-efficient order

If you’re already taking or plan to take income from multiple sources, it’s important to consider how that will be taxed. When and how you take your money can make a big difference to how much tax you pay and ultimately how long it will last.

For example, if your retirement portfolio comprises a combination of pensions and ISAs, the order you choose to draw from the two can be important. Taking money little and often can make all the difference when it comes to reducing your tax bill.

Make the most of ISAs

In short, draining your ISAs first can be a tax-savvy approach. There are two reasons for this. First, income from pensions is assessable to tax whereas with ISAs it’s tax free. This means you get to keep more of the income you receive. You don’t pay any tax on the money you take from an ISA, which means any investment growth or interest you’ve earned is tax efficient.

Second, pensions, unlike ISAs, are generally considered outside your estate, so upon death any money in your personal pension or SIPP can pass to your heirs free from inheritance tax (IHT). If you die before age 75, they can inherit the lot without paying a penny in tax, whereas if it happens after this point, they will pay income tax on any withdrawals at their marginal rate.

By using any ISA savings you have first and delaying accessing to your pension money, you’re also giving it more time to stay invested and grow in value. This in turn could increase your tax-free cash entitlement as well.

If you’ve already started taking an income from your pension – don’t worry – you could use your ISA savings to supplement that income. This could allow you to take smaller payments from your pension and mean you pay less income tax overall.

However, be careful not to empty your ISAs. You never know what life might throw up, so it’s crucial to keep some accessible money that you can dip into should the need arise.

Use any remaining tax-free cash wisely

Most defined contribution pensions allow you to take 25% of the fund tax-free from age 55 (rising to 57 in 2028), and this is clearly worth maximising. But you don’t have to take the lot in one go – staging withdrawals can often be a prudent strategy.

Time your pension withdrawals effectively

When it comes to taking income from your pension, you should only ever take out what you need.

That’s because pensions grow free from capital gains tax (CGT) and income tax and, are typically IHT exempt. Anything you draw from your pension that isn’t spent will form part of your estate on death and could be taxed at 40%. And unless you put all the money into an ISA, any future gains or interest will be taxable, too. It’s worth noting that there are also limits for paying into your pension once you’ve accessed it.

It’s likely that the more money you take out, the more tax you’ll have to pay, although how much will depend on which tax band your income falls into.

So if you take all of your pension savings at once, or in big lump sums, you could be paying more tax than you need to. But by taking your pension savings over a number of years and taking just enough to stay in the lowest tax band you can, you could keep more of your money overall.

Consider gifting

While topping up your own pensions and ISAs can still make plenty of sense when you’re retired, the decision should be weighed up against your broader financial needs.

For example, protecting your wealth from IHT might be a bigger priority, especially if your retirement portfolio is already adequate to see you through old age. If this is the case, you may choose to gift family members or charities.

Giving gifts while you’re still alive is one way to reduce the value of your estate and therefore reduce your potential inheritance tax bill. Some gifts are exempt, which means the value of them leaves your estate immediately. There are two notable gifts that will be exempt:

First, is the ‘annual exempt amount’ - this allows you to gift up to £3,000 each year split between as many recipients as you like. And if you didn’t use this in the previous tax year, you can bring it forward one year and give yourself up to £6,000 to give away.

Second is the ‘small gift exemption’ - this allows you to make as many gifts of up to £250 as you choose in a year, as long as each one goes to a different person.

You can also give away any extra income you have that you don’t need to fund your current lifestyle as regular gifts such as paying a family member’s rental income – the value of those will normally leave your estate immediately.

There’s a lot you can do to make sure that you leave as much as you can to the people you choose rather than to HM Revenue and Customs. But it’s important to understand the tax landscape to make sure your gifts are effective and make use of the various exemptions and allowances available.

The best way to navigate passing on your assets and manage a potential inheritance tax bill will entirely depend on your individual circumstances. There’s a lot of free guidance available online but given the sensitivity and possible complexity of passing on personal wealth, you may want to consider additional advice.

How much tax should I be paying?

Paying too much tax in retirement is an easy trap to fall into. A financial adviser can help make sure that you take your retirement income in the most tax-efficient way possible.

Remember though that tax and legislation may change, and your own individual circumstances, including where you live in the UK, will have an impact on your tax treatment.

Financial advice is accessible

Nowadays, financial advice is very accessible and affordable. You can even get advice from the comfort of your own home, with many providers now offering online and phone support at a time that suits you.

While there’s generally a charge for advice services, this could pay for itself in the long run by way of improved returns on your money, tax savings and, importantly, peace of mind.

Find out how abrdn's financial planning services could help with your retirement planning.