Your retirement income could be taxed – here’s how to get your return right

Frozen tax thresholds and rising state pension payments could push more pensioners into having to file self-assessment returns – but there are ways to keep more of your retirement income for yourself.

Last year, 1.8 million over-65s had to fill out a return, an increase of 100,000 compared to five years ago, despite government efforts to kill off self-assessment.

So, who needs to worry?

If your main source of income is already from a private pension, then you may not need to worry about filing a tax return as HM Revenue & Customs (HMRC) automatically takes what it is owed from drawdown or annuity payments.

But HMRC will also want to know about other money you are receiving, such as rent from a buy-to-let portfolio.

Additionally, as state pension payments rise, more people could find themselves in higher tax brackets and caught by the self-assessment net.

“With the triple lock increase in 2024 and the highest savings rates seen for years, thousands of pensioners are going to be paying income tax for the first time since their retirement, and with this comes a responsibility to pay all the tax that is due, whether it’s taxed at source or not”, says Samuel Gee, director of Manning Gee Investments. 

This makes it all the more important to plan how and when to access your retirement income so you can ensure more of your money goes towards your retirement years – instead of the tax man.

Here is how pensioners can prepare for a self-assessment tax return. 

What tax do pensioners pay?

HMRC doesn’t forget about you once you reach state pension age, which is currently 66.

Any money you take from a private or workplace defined contribution or defined benefit pension will be taxed “at source” so you will get the money after HMRC has got its slice. The state pension is paid “gross”, before any tax is due.

There may be other undeclared income though that needs to be taxed and declared on a self-assessment form.

This could include income from state pension payments, untaxed rent from a buy-to-let portfolio as well capital gains if you sell assets and charges for income earned on dividends.

The deadline is October 31 to return paper self-assessment forms to HMRC, so that has already passed, or you have until January 31 to file your return and pay any tax due online.

The state pension tax trap

The state pension is currently worth £10,600 per year and is set to rise under the “triple lock” to £11,502 from next April.

Income tax is owed on these payments, but many would have escaped this in the past if their earnings were below the personal income tax allowance threshold of £12,570.

The new, higher state pension, though, is getting close to the allowance, which has been frozen until at least 2028. If you are still working or have other sources of income, it is highly likely you’ll burst through the limit.

That makes pensioners victims of “fiscal drag” – where more income becomes taxable without tax rates actually rising.

“If you were still working and decide to take your state pension, you may find you’ve pushed your income into a higher tax bracket,” says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.

The importance of timing

If you haven’t already taken your state pension, it may be worth deferring it until you actually need it. That could be once you stop working and could lower your tax bill.

This has an added benefit, as for every nine weeks that you defer, you will get an extra 1pc state pension income when you do take it.

“This works out at around 5.8pc extra per year – the old ‘basic’ state pension system was even more generous at more than 10pc per year when you deferred it,” adds Morrissey.

“This is a good option if you don’t need to take a state pension straight away though you will need to balance this with the fact that it will take many years living in retirement before you make that money back.”

It is also worth planning how and when you take your private pension income as while this is automatically taxed, it can also influence whether you end up with a self-assessment bill if you have income from elsewhere.

The golden rule, says Morrissey, is to only take income you really need.

Retirees can take 25pc of their pension tax-free with income tax due on other withdrawals, but this may be higher than you expect.

“Many people accessing their pension for the first time are shocked to find they have been taxed over and above what they should have done,” adds Morrissey.

“This is because HMRC will tax you on what is known as a ‘month one’ basis – in other words they think you will repeat that large withdrawal every month and tax you accordingly.”

If this has happened to you, then you can fill in a P55 form to reclaim the overpaid tax.

Don’t waste your withdrawals

One mistake some pensioners make is taking money out of their retirement pot and then putting it into savings or an Isa.

Joshua Gerstler, chartered financial planner at The Orchard Practice, warns this is a bad idea as it adds to your earnings and will be liable for income tax.

“Unless there is a need to do so, I do not want someone taking money out of a tax efficient investment, costing themselves thousands of pounds in tax, to then put it somewhere else,” he says.

“For a higher-rate tax payer, the investment would need to grow by about 67pc to recoup the 40pc paid in tax.”

Beyond pensions

Pensions are just one way to manage your living costs in retirement.

Gee adds that as well as taking pension withdrawals tax efficiently, pensioners should make use of their £20,000 Isa allowance and other tax allowances such as the £1,000 personal savings allowance – dropping to £500 for higher-rate taxpayers.

Know your tax breaks

There are some tax reliefs and allowances that can help reduce anyone’s self-assessment bill.

Pensioners with a buy-to-let portfolio can make use of the property trading allowance on the first £1,000 of rental income but any rental income beyond £2,500 a year needs to be reported to HMRC via self-assessment.

You can also claim certain allowable expenses on rental property such as repairs and there is 20pc relief on mortgage interest payments, which can reduce your tax bill.

Your bill can also be reduced if you give money to charity.

Some allowances are changing though, so you may want to time when you take certain income to reduce any potential tax owed. For example, there was a dividend allowance of £2,000 for the 2022-2023 tax year but this has dropped to £1,000 in 2023-2024 and then drops further still to £500.

Similarly, the capital gains tax allowance for 2022-23 was £12,300, but this has been reduced to £6,000 for 2023-24 and will then halve again to £3,000 from 2024-25.

There are also two reliefs that have been phased out in recent years but are still available for older pensioners. If you are married or in a civil partnership and were born before 6 April 1935, you may be able to claim the Married Couple’s Allowance, which could reduce your tax bill by between £401 and £1,037.50 a year.

The husband’s income is used to work out allowance for marriages before 5 December 2006 but it is the income of the highest earner that is used after this date.

There is an income limit of, currently, £34,600, after which the allowance is reduced from the maximum £1,037.50 to £401 per year

HMRC has an online calculator where you can work out how much you could be entitled to. Older pensioners in these age brackets may also qualify for maintenance payments.

This reduces your income tax bill if you make maintenance payments to an ex-spouse or civil partner. The relief is worth 10pc of the maintenance you pay to your ex-spouse or civil partner up to a maximum of £401 a year.

“Unless you use them (tax allowances), you may lose them, costing you unnecessary tax,” Gee adds.