How to avoid a large tax bill when cashing in pensions

Mike Ambery is retirement savings director at Standard Life. Croner.

With inheritance tax on pension pots just months away, beware the risk of cashing in pensions quickly without assessing tax implications, warns Mike Ambery, retirement savings director at Standard Life.

Tax is becoming an increasingly important part of how people think about their pensions, particularly as inheritance tax (IHT) changes loom from next April. For some, this prospect may lead to decisions about accessing their savings earlier than they otherwise would have.

However, it’s important to weigh it up carefully - taking money out sooner can mean bringing forward income tax liabilities, and in some cases paying more than expected. Fully withdrawing means you may also lose out on potential investment returns, depending on what you do with it next.

Top tax tips

1. Watch the £50,000 and £125,000 thresholds

Income above £50,270 moves into higher rate 40% tax, and above £125,140 into the 45% additional rate (although the banding works differently in Scotland). What often happens is that a single withdrawal can push people across both thresholds in one go, which significantly increases the amount of tax they pay.

Taking a step back and working out how a withdrawal fits alongside your other income can help avoid this. Spreading withdrawals across tax years is one of the simplest ways to manage this more effectively.

Importantly, pension flexibility means tax-free cash doesn’t have to be taken as a single event. Taking your time and seeking guidance or advice where possible can help you make the most of the options available and manage your tax position more effectively.

2. Factor in your state pension

A full state pension uses up over 99% of the basic rate personal allowance of £12,570, which means there may be very little tax-free headroom left for other income. As a result, additional withdrawals from a private pension could be taxed from the first pound.

It’s an important point that can easily be overlooked when planning retirement income. Factoring this in early can help avoid unexpected tax bills later on.

3. Don’t take it all at once: Withdrawing your entire pension pot in one go is often the most expensive option from a tax perspective. While it can be tempting to take control of the money straight away, doing so can push much of it into higher rate tax. In many cases, taking withdrawals gradually over time can reduce the total tax paid. This approach can also provide more flexibility as circumstances change.

4. Use your tax-free cash carefully

Up to 25% of your pension can usually be taken tax-free, but that doesn’t mean it all needs to be taken upfront. Phasing tax-free cash alongside taxable withdrawals can help smooth out your overall tax position. This can be particularly helpful for managing income across different years. Taking a more gradual approach often helps people make the most of what they’ve built up.

5. Pause and check before you act

Decisions about pensions can be difficult to reverse, so it’s worth taking a moment to check the implications before making a withdrawal. Fully withdrawing may also restrict your ability to save into your pension in the future due to the money purchase annual allowance (MPAA) which reduces your allowance if you start taking taxable income from a pension.

A quick calculation or a conversation with a specialist can help you understand the potential tax impact. This doesn’t need to be complicated, but it can make a real difference.

6. Consider guidance or advice before making decisions

Pension decisions can have significant long-term implications, and taking all your pension at once could leave you financially vulnerable, especially if you rely solely on the state pension. It’s therefore worth taking the time to understand your options before making a withdrawal.

If possible, full financial advice can provide a more personalised view based on your circumstances and help you weigh up the trade-offs. There are also free sources of guidance available, such as the government’s Pension Wise service, which can help explain how pensions work and what to think about before accessing your savings.