3.5 Pension Tax Traps and Planning

Pension Tax Traps and Planning Tips

Pension freedoms give you flexibility — but they also create tax risks. From pushing yourself into higher tax brackets to triggering contribution limits, it’s easy to make costly mistakes. This chapter helps you draw income smartly and avoid common traps.

Common Pension Tax Pitfalls

1. Paying Too Much Income Tax

Pension withdrawals (beyond your tax-free lump sum) are taxed as income.

• If you take large one-off sums, you may push yourself into a higher tax bracket
• Pension providers often use emergency tax codes on your first withdrawal

Planning tip:

• Spread withdrawals across tax years
• Contact HMRC or use form P55 to reclaim overpaid tax on pension payments

2. Triggering the Money Purchase Annual Allowance (MPAA)

If you take taxable income from a DC pension (e.g. via UFPLS or drawdown), the MPAA may apply.

• It reduces your future pension contribution allowance from £60,000 to £10,000
• Applies only once you take taxable income (not just tax-free cash)

Planning tip:

• If you plan to continue working and contributing, avoid triggering MPAA
• Consider taking only the tax-free lump sum initially

3. Taking Income Too Early or Too Fast

You can access pensions from age 55 (rising to 57 in 2028), but:

• Early withdrawals reduce future income due to compounding losses
• You may still have income from work — creating inefficient tax overlap

Planning tip:

• Consider using other savings first (e.g. ISAs)
• Delay accessing your pension to allow for growth and deferral

4. Ignoring Personal Allowance Planning

Every UK taxpayer has a Personal Allowance (£12,570 in 2024/25).

• If unused, it’s wasted
• If exceeded, you may pay 20%, 40%, or even 45% income tax

Planning tip:

• Draw just enough pension income each year to fill your tax-free allowance
• Combine with ISAs or dividend income to stay tax-efficient

5. Forgetting About Inheritance Tax (IHT)

Pensions can be passed on tax-free in many cases — but not if you withdraw the money and hold it in cash or investments.

Planning tip:

• Leave pensions untouched if your estate is near the IHT threshold
• Pass on pensions directly (especially if under age 75 at death — beneficiaries pay no tax)

Smart Withdrawal Strategies

There’s no one-size-fits-all answer — tax planning should be reviewed regularly, especially around retirement transitions.

Income Tax Bands and Allowances (England, Wales, NI)

Income Tax Bands and Allowances (Scotland only)

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Summary: Key Pension Tax Planning Do’s and Don’ts

Next Chapter Preview:

We’ll walk through real-life retirement income strategies — blending pensions, ISAs, annuities, and part-time work to meet lifestyle and tax goals.

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