Pensions, like most forms of income, incur taxes. However, there are ways to ensure you’re not unnecessarily overpaying in tax, even when you’ve retired.
Are you approaching retirement and worried about the tax bite on your hard-earned pension? You’re not alone! One of the biggest shocks for many new retirees is discovering just how much of their pension gets eaten up by taxes. But don’t worry – there are legitimate ways to minimize your tax burden and keep more of your retirement money in your pocket.
I’ve spent weeks researching this subject and have put together a list of the best ways to lower or avoid paying taxes on your pension. Let’s get started!
Understanding How Pensions Are Taxed
Before we explore tax-saving strategies, it’s important to understand the basics of pension taxation:
- Most pension income is taxable at ordinary income tax rates
- Your pension is generally combined with other income sources to determine your total tax liability
- The 2023/24 personal allowance (the amount you can earn before paying income tax) is £12,570
- After this threshold, you’ll pay 20% tax on income up to £50,270, then 40% on income between £50,271 and £125,140
The good news? There are multiple ways to minimize your tax burden that are completely legitimate.
7 Smart Strategies to Reduce Taxes on Your Pension
1. Make a Direct Rollover to an IRA
Directly rolling over your pension to an IRA is one of the best ways to keep your pension from being taxed right away.
According to BenefitsLink, employers of most pension plans are required to withhold a mandatory 2020% of your lump sum retirement distribution when you leave their company. You won’t have to pay this tax, though, if you move the money directly to an IRA rollover account or another good plan. “.
Important: If you get a pension check personally (even if you plan to put it in an IRA), your employer has to hold 20% of it for taxes. Set up a direct trustee-to-trustee transfer so that you never touch the money.
2. Withdraw Only What You Need
Many retirees make the mistake of withdrawing large amounts from their pension all at once, which can push them into higher tax brackets.
Instead, consider withdrawing only what you need for your immediate expenses. This keeps more of your money growing tax-deferred while potentially keeping you in a lower tax bracket.
3. Utilize the 25% Tax-Free Portion (UK Pensions)
In the UK, you can typically take 25% of your defined contribution pension as a tax-free lump sum (subject to a maximum of £268,275). But you don’t have to take it all at once!
Consider “phasing” your tax-free cash by taking smaller portions over time. This can supplement your income while keeping your total annual income below higher tax thresholds.
4. Consider Moving to a Tax-Friendly State
Where you live can significantly impact your pension tax burden. According to SmartAsset:
“Some states fully tax pension income, while others tax part or none. Nine states have no state income tax, and many others offer at least partial exemptions for pension income.”
If you’re willing to relocate in retirement, moving to a state with favorable pension tax treatment could save you thousands of dollars annually.
5. Spread Out Lump Sum Distributions
If you’re taking a lump sum distribution from your pension, consider spreading it across multiple tax years if possible.
As Denise Lamaute explains in the BenefitsLink article: “For any portion of your lump sum retirement distribution that is not rolled over within 60 days of receiving your retirement check, you can expect to pay taxes at your tax bracket rate. What’s more, if you are under age 59 1/2 at the time you receive your retirement distribution, you will be hit with an additional tax penalty equal to 10% of any amount not rolled over.”
6. Understand Special Exceptions
Some pension income might be partially or fully tax-exempt. For example:
- Military pensions may be exempt from state taxes in some states
- If you made after-tax contributions to your pension, a portion of your distributions may be tax-free
- Some government pensions have special tax treatments
7. Balance Pension Withdrawals with Other Income Sources
Be strategic about which accounts you tap for retirement income. For example, you might:
- Draw from taxable accounts first while delaying pension payments
- Combine small amounts from different sources to stay in lower tax brackets
- Use Roth IRA withdrawals (which are tax-free) alongside taxable pension income
Real-World Example: The Cost of a Botched Rollover
Let’s look at a concrete example from the BenefitsLink article:
“If you were due to receive a $100,000 lump sum distribution and your former employer withheld $20,000, you’d pay $7,600 (38% tax bracket) in taxes. If you are younger than 59 1/2, you’ll be hit with an additional 10% tax penalty equal to $2,000. Your tax bill on your $20,000 will then be $9,600 versus ‘0’ with a complete rollover.”
That’s nearly $10,000 in unnecessary taxes that could have been avoided with proper planning!
Common Questions About Pension Taxation
Do I have to pay taxes on my state pension?
In the UK, the full new state pension is currently £203.85 per week, or £10,600.20 per year. Since this falls below the personal allowance of £12,570, you won’t pay income tax on just your state pension. However, if you have other income that pushes your total above the personal allowance, then portions of your income will become taxable.
At what age do I stop paying taxes on my pension?
Unfortunately, there’s no magic age when your pension becomes tax-free. As SmartAsset notes, “Taxes aren’t determined by age, so you will never age out of paying taxes.” Your tax liability is based on your income level, not your age.
Can I avoid taxes completely on my pension?
While you typically can’t avoid all taxes on pension income, you can potentially minimize them significantly. The strategies outlined above can help reduce your tax burden to the minimum legally required.
What happens if I take my entire pension as a lump sum?
Taking your entire pension as a lump sum could result in a much higher tax bill. Not only might it push you into a higher tax bracket for that year, but if you’re under 59½, you could face an additional 10% early withdrawal penalty on portions not rolled over properly.
Working with a Professional
The tax implications of pension withdrawals can be complex. While I’ve provided some general strategies, everyone’s financial situation is different. Working with a qualified financial advisor or tax professional can help you develop a personalized strategy to minimize your tax burden.
They can help you:
- Understand the specific tax rules that apply to your pension
- Create a withdrawal strategy that minimizes taxes
- Balance pension income with other retirement income sources
- Stay updated on changing tax laws that might affect your retirement
Final Thoughts
While you can’t completely avoid taxes on most pensions, with careful planning, you can significantly reduce your tax burden. The key is being strategic about how and when you withdraw your pension funds.
Remember these key points:
- Direct rollovers to IRAs can avoid immediate taxation
- Taking only what you need can keep you in lower tax brackets
- Understanding your tax-free allowances is crucial
- Where you live affects how your pension is taxed
- Spreading distributions across tax years can lower overall taxation
By implementing these strategies, you can keep more of your hard-earned pension and enjoy a more financially comfortable retirement.
Have you used any of these strategies to reduce taxes on your pension? Do you have questions about minimizing your pension tax burden? Drop a comment below and let’s discuss!
Disclaimer: This article is intended for informational purposes only and should not be construed as tax, legal, or financial advice. Tax laws change frequently and vary by location. Please consult with a qualified tax professional regarding your specific situation.
How much will I be taxed on my pension?
Another frequently asked question is “how much tax do you pay on your pension?”. As stated above, the amount of income tax you pay on your pension depends how much income you draw from your pension.
The good news, is that some of your pension is, in fact, tax free. If you have a defined contribution pension, whereby your pension is based on how much you and/or your employer have saved into it — which is the most common kind — then you can take out 25% of your pension completely tax-free, subject to a max of £268,275, this is known as the Lump Sum Allowance (LSA).
It’s important to know that this doesn’t have to be taken out all at once, even though that is possible. It is possible to take out multiple smaller lump sums each with 25% tax-free, or just take portions of tax-free cash over time rather than all at once (known as phasing), as long as your pension allows for ‘flexi-access drawdown’. The remaining 75% will be taxed according to the standard rules explained above.
If you are only receiving the new state pension, on the other hand, then you do not need to worry about income tax. As of 6th April 2024, the full new state pension is £230. 25 a week, or £11,973 a year. Since this is less than your personal allowance, you won’t have to pay income tax on it. Most people who have worked throughout their lifetime will be eligible for a state pension, although the amount you receive will depend on your national insurance record.
But if you get money from other sources that makes your yearly income more than £12,570, you might have to pay income tax.
Do you pay tax on your pension?
The short answer to this question is yes, so long as your pension exceeds the minimum threshold for paying income tax.
Income from a pension is taxed exactly like any other form of non-savings income. Firstly, everyone has a personal allowance, which is the amount of money you’re allowed to earn each year before you start paying income tax. Currently, the personal allowance is £12,570 (though this may be reduced if you have earnings above a certain level), so if you receive less than £12,570 per annum of taxable income, then you pay no income tax. Once your taxable income goes above this level you become liable to pay 20% income tax on taxable income between £12,571 and £50,270 per annum. This then increases to 40% income tax for taxable income between £50,271 and £125,140, and 45% beyond that. These income tax rates are valid as of 2025. For updated and current tax rates, see our latest tax tables.
It’s worth noting however, under certain circumstances, you do not need to pay tax on all of your pension income. Additionally, there are strategies you can adopt to minimise the amount of tax you pay on your pension.