How to avoid paying tax if you’re on the State Pension
WHILE some dream of a retirement spent holidaying around the world, the reality is that for many it is a time of constant financial hardship.
And with the cost of living rising and key benefits like the Winter Fuel Payment being stripped away from many households, making ends meet is only going to get harder.
That’s why it’s so important to make sure you’re not paying more tax than you need to so you get to keep as much of your cash as possible.
The money you get from the state pension and any private pensions you have is taxed just like your income was in your working life.
That means it’s taxed at what’s called your “marginal rate”.
The first £12,570 is tax-free (as long as your annual income is less than £100,000), then everything up to £50,270 is taxed at 20%.
Income between £50,271 and £125,140 is taxed at 40% and everything above that is 45%.
It’s important to remember than you only pay the higher rates on the amount above each band.
For example, if you earned £55,000, you’d pay 0% on £12,570, 20% on £37,700 and 40% on £4,730.
The full state pension is currently £221.20 a week. Over a year, that adds up to £11,502.40.
If that’s your only source of income, you currently won’t pay any income tax at all.
However, as the state pension needs to rise by at least 2.2% each year under the triple lock, and often goes up far more quickly, experts predict that it could exceed the current personal allowance by 2026.
At that point, people who are only on the state pension would need to pay a small amount of income tax.
If you have income beyond the state pension, the likelihood is that you will have to pay some income tax.
That’s because after the state pension, you only have £1,067.60 left in personal allowance.
The only way to avoid income tax altogether is to make sure you stay under the personal allowance entirely, but the reality is that most people need more than that to live on and have some other income.
For instance, the Pensions and Lifetime Savings Association (PLSA) estimates that a single person needs at least £14,400 to have a simple retirement, £31,300 to have a moderate retirement and £43,100 to have a comfortable retirement.
However, even though you will usually have to pay income tax at all those levels, there are simple things you can do to make sure you’re not paying more tax than you need to.
Tax-free cash
The first thing to do is to take advantage of your tax-free cash. All private and workplace pensions in the UK allow you to take 25% completely tax free.
You can do this all in one lump sum, or by only paying tax on 75% of each withdrawal you make – depending on how you access your pension.
If you have a pension worth £100,000, that means you get £25,000 completely tax-free.
If you’re aiming for the simple retirement figure of £14,400 a year, that tax-free cash could mean eight years where you pay no tax at all.
You’d have £11,502.40 in state pension (at current rates) and you’d only need an extra £2,897.60 to hit your goal.
Never take more than you need to
The next golden rule of retirement is to never take more cash out of your pension than you actually need in the tax year, as this can push you into a higher tax band.
For instance, if you only need £50,000 to live on, but you withdraw £55,000, then you’ll pay 40% tax on the money you didn’t need, rather than just 20%.
The biggest mistake people often make is withdrawing their whole pension pot and then leaving it in their bank account.
This has three negative effects.
The first is that you’ll typically pay higher tax, the second is that your money is no longer invested and growing and the third is that it becomes part of your estate for inheritance tax purposes.
From a tax perspective, the effects can be devastating. Imagine you have a £150,000 pension pot.
After you’ve taken the 25% tax-free lump sum, you’re left with
£112,500.
If you then withdrew £5,000 a year for 22 years alongside the full state pension but had no other taxable income – you’d pay £786.40 a year in income tax.
In total, that adds up to £17,300.
If you withdrew the whole amount, you’d pay £39,646.75 straight to the taxman.
That means you’d be £22,345.95 worse off.
Check all your income sources
The other top tip is to look at other income sources you might have, particularly ISAs.
ISAs are withdrawn completely tax free, so these can help you reach your target income while still paying lower income tax.
A financial adviser can help you to structure your income so that it is as tax efficient as possible.
They can also walk you through all of the different available options for accessing your retirement savings.
You can find one on unbiased.co.uk.
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.
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