How to avoid the common pension tax mistake catching 86 per cent of people

The majority of pension savers are at risk of running up huge tax bills when they take money out of their pots, according to a recent study of over 3,000 people.

Millions of savers risk making poor decisions about their pensions in cases where their providers’ guidance is too basic, the research, carried out by the Association of British Insurers (ABI), found. If savers are given more thorough, personalised advice the risk was found to significantly reduce.

Since the introduction of pension freedoms rules in 2015, pension savers have been able to access their money much more flexibly – but with greater withdrawals comes greater chance of being landed with a huge tax bill, especially given the expense of going to a financial adviser.

Here, Telegraph Money explains how to avoid the most common pension mistake – and what your options are if you need more help with your finances in retirement.

The pension tax question most pension savers get wrong

Having access to detailed information about your pension savings, and the tax bills you might have to pay when you make withdrawals, can make a huge difference to pensioners’ finances. 

Armed with just generic information about how to withdraw pension savings without incurring a 40pc tax bill, just 14pc of older savers were able to identify the best financial outcome when faced with a hypothetical scenario.

If replicated in real life, it could mean thousands of pensioners are paying more tax than they need to in retirement.

The key rule to remember is that you are usually entitled to take up to 25pc of your pension savings as a tax-free lump sum. Any further withdrawals are added to your other income, and the money is therefore considered taxable.

Sir Steve Webb, partner at pension consultants LCP, said: “There’s no doubt that many people have very limited understanding about the consequences of taking their pension as a lump sum, especially as regards to the risk of a large tax bill.” 

In the ABI’s study, savers were asked how a 62-year-old woman earning £40,271 a year could withdraw enough money from her £20,000 pension to repay a £10,000 loan, and help her granddaughter pay some bills, without racking up a huge tax bill. 

To achieve the best result, the woman in question should withdraw between £11,800 and £13,300 from her pension as a lump sum. 

Thanks to being able to withdraw some of her pension tax-free, even when added to her £40,271 income these sums won’t exceed the higher-rate £50,270 threshold. 

If she instead chose to withdraw her £20,000 in full, she’d end up with a £4,000 tax bill.

When can you start making pension withdrawals?

If you have a defined contribution (DC) pension, you can start taking money from when you turn 55 – rising to 57 in 2028.

Once you start taking money from your pension, not only will you need to factor in the tax implications of receiving this extra income, but it also changes how much you can save in the future. 

After your pension is moved to an “income drawdown” account – eg if you have started taking flexi-access drawdown income from the pot – the maximum amount you can pay in each year reduces to £10,000, down from up to £60,000 previously.

The key consideration is how much you can afford to take. With an increasing number of people living to 100, pension savings have to fund your living expenses for a long time – and may even need to stretch to cover care costs, too. 

To help gauge how much you can afford to withdraw each year, use our calculator below, which can give you an idea of how old you’ll be when your pension runs out. If it’s younger than you’d like, then you might want to rethink your spending plans.

How to get free pension guidance 

Pensions, and the tax your savings incur, are complicated topics, and it’s unsurprising that many savers struggle to understand how their actions will affect their tax bill. 

Financial advisers typically charge 2.4pc of your pension pot upfront and 0.8pc for ongoing advice, according to the Financial Conduct Authority (FCA). For many, this puts getting advice about their pension outside of their budget. 

However, if you still feel that you want to speak to someone about your specific situation, PensionWise is a service from government-backed MoneyHelper, which offers a free appointment to over-50s with a defined contribution pension pot. This could be a personal or workplace pension – but note that defined benefit pensions are not covered.

By booking a free appointment – most of which last for an hour – a pensions specialist can help you explore your options for taking your retirement funds, and the tax implications of each. 

However, they can’t suggest specific investments – unlike a financial adviser. Appointments can take place in person, over the phone, or use the Pension Wise online tool if the former options aren’t suitable. 

If you want a family or friend to attend the appointment on your behalf, or if you have a power of attorney covering property and finances, then you can either provide written permission or evidence.

To get the most out of your time, it’s best to do some preparation beforehand. 

Track down your pension accounts, and find out how much you have saved in each one. To get a fuller picture of your finances, it’s also worth finding an estimate for your state pension entitlement, and any other sources of income you’re likely to have in retirement – whether that’s rental income, savings or investments. 

At the same time, detail any debts, such as a mortgage, and at what age you plan to stop working. The expert can take your personal circumstances into account when discussing your pension options.

Afterwards, you can download or print a summary of your appointment, setting out the options you discussed and what they mean for your finances.

How to get discounted pension guidance

The pensions advice allowance lets you withdraw £500 from your pension tax-free for retirement advice, and can be used by both members and beneficiaries. This counts as a new authorised payment, and therefore won’t trigger an unauthorised payment charge.

You can use the allowance only once in a tax year, and a maximum of three times overall. Under the employer-arranged pensions advice “exemption”, your employer can also put £500 towards pension advice. 

Used in combination with the pensions advice allowance, this would help you save £1,000 on advice fees in one year. However, bear in mind that not all pension providers will offer this service. 

How to find a financial adviser

If you still feel you need extra help with your pension options, such as requiring help planning to pay for care, or complex inheritance planning, then a regulated financial adviser can offer specific advice. 

Our guide can help you find a financial adviser – and suggests what to do if you’re not happy with their advice.