Avoiding the Retirement Tax Trap

• Personal Allowance: £12,570 p.a. per person
  • Protect it! When adjusted gross income exceeds £100k, the Personal Allowance is tapered by £1 for every £2; until it reaches £0 at £125,140 – an effective 62% marginal band when national insurance is factored in on top. Use pension contributions and other forms of salary sacrifice to avoid this cliff.
  • In retirement, use phased withdrawals to keep income-taxable drawdown below £100k each year.
    
• Income tax bands (England & NI for 2025/26):
  • 20% basic rate; 40% higher rate; 45% additional rate.
  • In retirement, these determine the marginal cost of pension/ GIA/ bond events: small changes in taxable income can move you across bands with significant tax consequences.
    
• Dividend allowance: £500 per person
  
• Savings allowance per person:
  • £1,000 (basic rate taxpayer), £500 (higher rate taxpayer), £0 (additional rate taxpayer).

Practical tip: Always start withdrawal planning by listing all taxable sources (rental income; realised gains; dividend income; taxable pension income). Tax bands and allowances should form the ‘frame’ for sequencing.

• Annual Exempt Amount: £3,000 per person
  • Use it every year – it cannot be carried forward.
    
• Rates (recently increased):
  • 18% within basic band;
  • 24% for gains above the basic band.
  • That tightening increases the potential value that can be gained from annual CGT harvesting and ‘bed & ISA’ tactics.

What is ‘bed & ISA’?

1. Sell the investment outside your ISA
   • You sell your shares, funds, or ETFs held in a general investment account (GIA) or similar.
   • This sale may realise a capital gain — but you can use your annual CGT allowance (£3,000 in 2025/26) to minimise or eliminate any tax liability.
     
2. Repurchase the same investment inside the ISA
   • Using the proceeds from the sale, you immediately repurchase the same investment within your ISA (or choose something else entirely).
   • Once inside the ISA, all future growth and dividends are tax-free.

Practical tip: Small, repeated sales in General Investment Accounts – timed to use Annual Exempt Amounts and avoid income band creep – materially beat large once‑off disposals taxed at the higher CGT rate.

Relevant primarily for Defined Contribution (DC) pensions

• Annual Allowance: £60,000 (or 100% of relevant earnings, whichever is lower).
  
• Tapered Annual Allowance:
  • Occurs where threshold income exceeds £200,000 and adjusted income exceeds £260,000
  • Allowance reduces by £1 for every £2 of adjusted income above £260,000, down to a minimum of £10,000.
    
• Money Purchase Annual Allowance (MPAA): £10,000
  • Triggered if you take flexible access of your pension; avoid accidental triggers!
    
• Tax‑free pension cash/ Lump Sum Allowance (LSA):
  • 25% of the total value of your pensions, capped at £268,275
    
• Lump Sum & Death Benefit Allowance (LSDBA): £1,073,100

Practical tip: After the removal of the Lifetime Allowance charge, one blunt cap was replaced with allowances and death‑benefit ceilings. Accessing the tax-free portion of your pension requires careful planning, as phased crystallisation can be more efficient than taking lump sums.

• ISA allowance: £20,000 per person
  
• Growth and income on assets held within the ISA are tax free.
  
• Withdrawals are tax free and do not count as taxable income – one of the most powerful levers in retirement sequencing.

Practical tip: Use ISAs to hold growth and yield assets that would otherwise generate taxable income in General Investment Accounts (GIAs) or pensions.

• 5% cumulative allowance per policy year: withdrawals up to 5% of initial capital investment (accumulative) are tax‑deferred (not tax‑free).
  
• On a later chargeable event, gains are treated as income. ‘Top‑slicing’ relief may reduce the effective tax.
  
• Segmentation (issuing multiple small bond segments) enables partial encashments without crystallising the entire bond.

Practical tip: Bonds are sequencing tools – excellent for smoothing when you want to avoid lifting marginal taxable income.

Discretionary trusts carry entry charges, 10‑year periodic charges (up to 6%), and exit charges – all complex, but invaluable where control and estate planning are jointly required with income management.

Practical tip: Use bonds in trust to provide family controlled distributions while preserving beneficiary tax allowances.

From 6 April 2027, most unspent pensions and many pension death benefits will be included within estates for IHT purposes.

This is a structural change: the once‑automatic IHT shelter provided by pensions will no longer be universally reliable.

Practical tip: Planning that relied on “leaving wealth in pensions forever” should be re‑examined. Sequencing may shift towards partial de‑risking and movement into ISAs/ trusts/ bonds where appropriate.

Often overlooked in drawdown, the New State Pension applies to men born on or after 6 April 1951, and women born on or after 6 April 1953.

New State Pension (full rate): £230.25 per week, or about £12,005 per year.

Qualifying years:

• Minimum 10 years of National Insurance (NI) contributions or credits needed to receive any pension.
• Full rate requires 35 years of contributions or credits.

Protected payments: If your earnings record from before April 2016 would give you a higher payout under legacy rules, you may receive that as a “protected payment” on top of the current full rate.

Deferral increases entitlement by ~1% every 9 weeks (~5.8% p.a.).

The “triple lock” policy guarantees the New State Pension will rise by the larger of: inflation (CPI), average earnings growth, or 2.5%. In 2025–26, the increase was 4.1%, based on average earnings growth from May-July 2024.

The government has launched the third review of the State Pension age, to determine whether pension age should be automatically linked to life expectancy, possibly raising it even further. The current plan already includes raising the age to 67 by 2027-2028 and to 68 by 2044-2046.

Build a 10- to 30-year plan, that models the net income required each year, stress tested for market downturns and longevity. This should account for irregular outgoings too, such as travel, contributing to school fees, property works, gifting, and care contingencies.

An expert financial adviser will use sophisticated cashflow modelling software that considers a variety of scenarios.

Define which savings and investment pots are tax‑free, tax‑deferred, taxable and trust/ legacy oriented.

• Tax-free: ISA
• Tax-deferred: Pensions & Bonds
• Taxable but manageable: GIA
• Plus, those which are Trust-based to offer control & IHT shaping

• Use allowance‑rich pots first and leave taxable pots to years where other income is low;
• Keep taxable income inside lower bands/allowances;
• Harvest CGT each year without eroding core capital;
• Maintain optionality for later-life and estate outcomes.

Share key allowances between spouses;

• Personal Allowance
• CGT Annual Exemptions
• Dividend allowances

…to avoid higher tax bands as individuals.

Avoid locking all capital into illiquid or high-penalty structures.

For example, pensions generally cannot be accessed until age 55 (rising to age 57 in 2028), and now face potential double taxation inside estates for IHT purposes.

• Harvest allowances;
• Move assets to ISAs when appropriate;
• Re-sequence if income profile changes;
• Crystallise gains;
• Reset bond segments; and
• Top up a 2-3 year cash bucket so markets don’t dictate tax timing.

Core rules:

• Up to 25% tax-free, but limited by LSA £268,275 (protections aside). Remainder taxed at your marginal rates.
  
• Contributions: Annual Allowance £60k, taper from £260k adjusted income (min £10k). MPAA £10k if flexibly accessed.
  
• Flexi-access drawdown vs UFPLS: both create taxable income beyond the tax-free element; beware Emergency (Month-1) tax on first payments; reclaim via P55/ P53Z/ P50Z.

What they do well:

• Tax relief on contributions;
• Tax‑deferred compounding;
• Structured death benefits (beneficiary rules).

Key constraints:

• Taxable on withdrawal beyond PCLS/ LSA;
• MPAA may restrict future contributions once flexible access is used;
• PCLS subject to LSA cap;
• 2027 IHT inclusion looms.

Pro moves:

• Earning between £100–£125k? Combine pension contributions and other salary sacrifice to reclaim or preserve Personal Allowance (effective 62% marginal relief zone).
  
• Phased crystallisation:
  • Crystallise small portions each year to realise up to 25% tax‑free cash (within LSA) and keep taxable income inside target bands.
  • Preferred to large UFPLS where MPAA or rate spikes may occur.
    
• PCLS-only first draws (where legally feasible) to avoid MPAA trigger in the short term. Document carefully.
  
• Pension contributions as tax-band management: for those near the PA taper band, an extra pension contribution or Gift Aid top‑up can reduce adjusted net income, restoring PA or reducing marginal rates. (Use with caution and model liquidity.)

Common mistakes:

• Emergency tax shock on first draw; plan cash and reclaim promptly.
  
• Taking a large UFPLS early, triggering MPAA or pushing into 45% band. Can trigger HICBC/ benefit cliffs for under-retirement-age households.
  
• Failing to segment crystallisations, losing LSA advantage or incurring unnecessary income spikes.

Core rules:

• Withdrawals are tax-free and don’t count as income for tax-band tests – ideal for smoothing income and avoiding higher-rate thresholds.
• £20,000 p.a. use-it-or-lose-it allowance per person.

What they do well:

• Tax‑free withdrawals;
• Tax-free growth and income on investments within ISAs;
• Do not count as taxable income;
• Ideal for smoothing tax bands.

Pro moves:

• Prioritise funding ISAs in accumulation years after covering tax‑efficient pension contribution needs.
  
• Family pooling: two spouses = £40k p.a.
  
• ‘Bed & ISA‘ GIA assets each year to migrate yield/ growth into a tax-free silo.
  
• Park high-yield or fast-growing assets inside ISA to silence tax drag.

Common mistakes:

• Putting low‑growth or defensive assets into ISAs, while leaving high‑growth investments in pensions/GIA – match asset to wrapper strategically.

Purpose:

Flexible, taxable accounts used for CGT harvesting, dividend management and bridging between tax‑sheltered pots.

Pro moves:

• Annual CGT harvesting: Crystallise up to £3,000 p.p. every year. Split across spouses for double allowance.
  
• ‘Bed & spouse’ transfers: Shift gains to the spouse with lower rates or unused allowances (watch out for 30‑day/ share-matching rules to avoid wash sales).
  
• Prefer funds with accumulation units where dividend stuffing would otherwise create tax drag.
  
• Target dividends within the £500 allowance; progressively migrate surplus yield into ISAs.

Purpose:

• Create tax-deferred cashflow via the 5% cumulative allowance – useful when you want spending power without lifting taxable income;
  
• Top-slicing relief may mitigate a large one-off encashment if held many years;
  
• Assignments (to spouse/trust) normally no gain/ no loss – can shift future gains to different taxpayers/structures;
  
• Useful in early retirement or when deterministic withdrawals are required.

Design tips:

• Segment policies at outset (e.g., 10–100 segments) to allow partial encashment without crystallising the whole bond;
  
• Match bond type to tax profile: onshore has a basic-rate credit; offshore maximises gross roll-up but gains are fully income-taxed when they arise.

Pro moves:

• Segment large bonds into multiple policies/ segments to allow partial surrenders;
  
• Use top‑slicing relief modelling when planning a large encashment;
  
• Assign to spouse or trust as part of intergenerational planning (assignment usually non‑taxable).

Common errors:

• Treating 5% as tax-free (it’s deferred); always model the eventual chargeable event with future expected income bands;
  
• Large future chargeable events can collide with high-rate bands or Personal Allowance taper.

Purpose:

• Control, protection, and IHT management for surplus capital;
  
• Ring‑fencing and bespoke distributions;
  
• Useful when a retiree wishes to provide controlled family income without inflating personal taxable income.

Key charges:

• Entry: ~20% on value above available Nil-Rate Band (NRB) for discretionary trusts;
  
• Periodic (10-year) charge: up to 6% above NRB;
  
• Exit charges apply on capital appointments.

Where Trusts meet retirement income:

• House surplus capital in trust (often using bonds) to deliver trustee-controlled distributions while ring-fencing from your personal bands/ means-tests.
  
• Time trustee distributions around beneficiaries’ allowances (e.g., adult children in low bands).

Pro move:

• Use trusts for pension death benefit holding where legislation permits (but seek legal advice).

1. ISAs first (withdraw tax‑free cash to meet most of the need).
   
2. Bond 5% allowances next (tax deferred).
   
3. GIA disposals up to CGT Annual Exemption.
   
4. Pension taxable draw only to fill remaining PA/ basic band headroom.

This maximises tax‑free draw, defers taxable draws until necessary, and avoids creeping into 40/ 45% income tax territory.

1. ISAs first;
   
2. Bond 5% allowances next (tax deferred);
   
3. Pension up to Personal Allowance only;
   
4. Harvest CGT Annual Exemption in GIA, but avoid creating dividend income beyond the £500 allowance.

Goal: Re‑weight pension‑heavy estates to reduce 2027 IHT exposure, without spiking marginal tax rates.

1. Cash & ISA top ups;
   
2. Phased crystallisation of smaller pension tranches to preserve PA and basic rate (not UFPLS lumps) to re-weight gradually from pension to ISA/ bond/ trust;
   
3. GIA to fund bed & ISA over multiples years;
   
4. Onshore bond assignment to trust where continuity of control is needed;
   
5. Life cover in trust to insure IHT if immediate migration impossible.Note: model run‑rate impact carefully; acting too quickly may crystallise gains or incur large income tax;
   
6. Maintain a cash buffer (2–3 years) to avoid forced selling in down markets, preserving tax control into 2027+.

Important: Your financial adviser shoudl model the run‑rate impact carefully; acting too quickly may crystallise gains or incur large income tax.

Two spouses age 60 and 58 target £80,000 annual expenditure.

Asset breakdown:

• Pensions: £900k (uncrystallised)
  
• ISAs: £450k
  
• GIAs: £500k
  
• Offshore bond: £300k (10 segments)
  
• Cash: £50k

Annual drawdown plan (year 1):

• Withdraw £40,000 from ISAs (untaxed)
  
• Withdraw £15,000 from offshore bond (5% allowance of £300k, tax deferred)
  
• Each crystallise pension income equal to Personal Allowance of £12,570, using PCLS to fund the tax‑free portion (zero taxable income)
  
• Realise £6,000 in gains from GIA (utilising annual exemption)
  
• Earn dividends up to £1,000 (utilising allowances); migrating high-yield positions into ISAs over time.

Net result:

~£80k cash flow with negligible/ zero current-year income tax; no CGT; bond withdrawals deferred; pensions largely untouched and compounding.

Why it works:

Layering tax‑free and tax‑deferred withdrawals plus spouse allowances to avoid higher bands.

Single age 62 targets £80,000 gross from their pension alone.

Income tax:

• First £12,570 at 0%;
• Next slice at 20%;
• Next slide at 40%
• Typical tax bill £20k-£25k+ p.a. (exact amount depends on other income).

At this rate the pension could run out entirely in less than 20 years, assuming 5% net growth. A quarter of the pension pot is lost unnecessarily to income tax.

This is avoidable if part-funded from ISA/ bond/ GIA to cap marginal rates and preserve allowances.

Asset breakdown:

• Pensions: £450k
  
• ISAs: £250k
  
• GIAs: £200k
  
• Onshore bond: £100k

Strategy:

• Years 1-5:
  • Withdraw from ISA (tax free);
  • Withdraw £5,000 from onshore bond each year (5% allowance of £100k, tax deferred)
  • Crystallise pension income equal to Personal Allowance of £12,570 each year
  • Harvest £3k CGT (within annual exemption) via GIA each year
    
• Years 6-10:
  • Phase pension crystallisations to keep within basic rate band (20%), avoiding higher income tax rates where possible;
  • Make gifts from surplus income
    
• Estate planning considerations:
  • Review pension nominations and possible bypass/ discretionary trust strategies for death benefits;
  • Consider writing a life cover plan in trust to meet an eventual IHT liability;
  • Gradually re-weight across wrappers.

Outcome:

Materially lower lifetime income tax and lower projected IHT exposure vs a pension-only draw.

Strategy:

• Split across two or more tax years if possible;
  
• Use ISA first;
  
• Use bond encashment with top-slicing analysis (consider partial segment surrenders);
  
• Pension: crystallise tranches to maximise PCLS and keep taxable slice within target bands;
  
• GIA: realise gains up to CGT annual exemptions across both spouses.

Crystallising small pension tranches each year (taking tax‑free element where available, and only taxable as needed) reduces marginal tax spikes and preserves MPAA headroom. Document precisely for HMRC (dates, amounts).

Issue multiple small bond segments (or purchase multiple small policies) to aid partial surrenders and preserve the 5% allowance across different policy anniversaries. When a larger encashment is required, estimate top‑slicing relief to reduce the effective tax rate.

Trustees can smooth distributions to beneficiaries so the household uses beneficiaries’ PA and lower bands, preserving the settlor’s tax bands and potentially keeping the settlor’s taxable income low (subject to trust tax rules).

Where wealth exceeds long‑term needs and IHT is a concern, measured regular gifting (within the normal expenditure out of income rules) can reduce estate exposure without incurring IHT charges. Keep precise records – to prove regularity to HMRC.