10 steps to generate a tax-efficient retirement income

No one wants to pay more tax than necessary, and those in retirement are no exception.

Thanks to the introduction of pension freedoms some 11 years ago, you now have carte blanche to draw from your savings however you wish. This flexibility has not only been great for broadening your pension withdrawal options but also created fresh tax-planning opportunities.

But there’s more to saving tax in old age than purely managing pension withdrawals. Here are 10 handy steps to keep your retirement portfolio away from HMRC.

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1) Clarify your retirement outgoings and income sources

The first task is to place tax planning to one side and instead calculate the outgoings needed to spend your golden years on your terms. This is about weaving tax efficiency into your goals rather than the other way around, with the aim to generate a sustainable income to support your desired lifestyle.

If you have or expect sources of guaranteed income - such as defined benefit (DB) pensions, annuities and the state pension - factor these in first. Note, they may kick in at different points, either by necessity or choice. For example, whether you’re in receipt of the state pension can inform the most tax-efficient withdrawal strategy, as I explain further down.

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Once you’ve mapped out your guaranteed income sources you can identify any shortfall that the flexible parts of your portfolio - self-invested personal pensions (SIPP), individual savings accounts (ISA) and other savings and investments - need to fill.

2) Understand the income tax thresholds

Streamlining your tax affairs requires a decent grasp of the tax rates and bands you’re working with. The UK’s system is constructed on what’s called a ‘progressive’ basis, meaning rates increase as your income rises.

Your various forms of taxable income are stacked up and taxed depending on what band they fall into. The first £12,570 is tax-free, you pay 20% on anything between £12,571 and £50,270, the rate is 40% on income between £50,271 and £125,140, and 45% above this figure.

For most, the goal is to stay within the 20% band, provided there’s no detriment to your lifestyle.

3) Know which income sources are tax-free and which aren’t

While the options for getting tax-savvy with any guaranteed income are limited, it’s a different story with your flexible savings.

From your SIPPs and ISAs to general investing accounts (GIA), knowing how income sources and withdrawals are taxed is key to managing your tax affairs in later life. Let’s separate the elements that are tax free and taxable.

Tax-free sources

• 25% of total pension savings, capped at £268,275, for most people
• ISA withdrawals
• First £500 of dividends and £3,000 of gains in GIA
• First £1,000 of savings interest (including bond income) is tax free for most basic-rate taxpayers, but this falls to £500 for 40% taxpayers. Additional rate taxpayers don’t get a savings allowance. Those on low incomes could earn £5,000 in interest, tax free.

Taxable sources

• SIPP withdrawals, beyond tax-free element, are taxed at your marginal rate
• GIA withdrawals on gains above £3,000 are taxed at either 18% or 24%, depending on income tax band
• Annual dividends above £500 in GIA are taxed at 8.75%, 33.75% or 39.35%. Note, the basic and higher rates will rise to 10.75% and 35.75%, respectively, in April 2026
• Interest (including bond income) above savings allowance is taxed at 20%, 40% or 45%, but will rise two percentage points in April 2027.

4) Create a plan for tax-free cash

Using the tax-free element of you pension wisely is a cornerstone of tax-efficient retirement planning. You can hook out the maximum in one hit, but don’t have to. Phasing tax-free withdrawals over time can produce a steady stream of tax-efficient income, using something called uncrystallised funds pension lump sum (UFPLS).

With UFPLS, 75% of your pension withdrawal is taxable, while 25% is tax free. Assuming the taxable portion falls within the basic-rate band, the effective tax rate on the amount taken drops to 15%.

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We must acknowledge that for some people, taking a large tax-free lump sum early in retirement is a sensible move, especially those with a purpose for the money.

But either way, before you make a tax-free withdrawal, make sure you have a plan for how to use it.

5) Use your personal allowance wisely, if possible

If you’re in receipt of your state pension and receive the maximum amount, your £12,570 tax-free allowance will largely be swallowed up. The full state pension is currently £11,973 and will rise to £12,548 from April 2026. The £12,570 threshold will remain frozen.

However, not everyone who’s retired will receive this amount. That might be because:

• You stopped work before reaching state pension age, which is currently 66 but gradually rising to 67 between April 2026 and April 2028, so are yet to claim it
• You retired before April 2016 and receive the basic state pension which pays £9,175 a year, increasing to £9,615 from April 2027
• You have less than 35 years qualifying national insurance (NI) contributions, so receive a reduced amount
• You deferred claiming your state pension.

Whatever the reason, if you have some or all of £12,570 tax-free allowance available, a savvy move is to fill it up with income that’s taxable, such as pension withdrawals. This is where UFPLS can be particularly useful.

Let’s say you have no regular or earned income so have the full £12,570 allowance spare. By making an UFPLS withdrawal of £16,760 from your pension, the full amount will be free of tax. That’s because the 75% portion that is taxable falls within your personal allowance, with the remaining £4,190 (25%) part of your tax-free cash.

What’s more, supplementing this with ISA withdrawals and keeping taxable income within the £12,570 personal allowance could enable you to earn £5,000 in savings interest without paying a penny to HMRC.

6) Bed & ISA holdings outside tax wrappers

Realising a profit up to your £3,000 CGT allowance isn’t technically classed as ‘income’, but it effectively works as a tax-free withdrawal. It’s worth making the most of this handy exemption every year as you can’t roll over any unused allowance.

Even if you have no need to spend or use the money, by shifting the proceeds into your ISA – a process called Bed & ISA - should you have enough £20,000 allowance spare, will protect future gains and dividends from tax.

7) Keep an eye on frozen tax thresholds

If you diligently try to keep your taxable income just below £50,270 to avoid the higher rate, be sure to monitor withdrawals annually.

This is down to a combination of two factors. First, some guaranteed income sources, notably the state pension and most DB schemes in payment, uprate every year. Second, at the Autumn Budget, the government announced that income tax thresholds will stay frozen until 2031, meaning annual income increases will eat further into your basic-rate band.

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Some strategic income manoeuvring within your portfolio, such as nudging down SIPP withdrawals and taking more from ISAs, can help you steer clear of the 40% band without compromising your lifestyle.

8) Consider pension funding if you breach 40% threshold

You may assume there’s little merit in paying into a pension once you’ve either partly or fully retired. However, in certain instances it’s a smart move.

Let’s say your regular retirement income is £40,000 but you took on some consultancy work during the tax year which paid £14,000, taking your total income to £54,000.

This means £3,730 would breach the £50,270 higher-rate threshold and face 40% tax, resulting in HMRC grabbing £1,492 on this sum.

But, provided you’re under age 75, there’s a solution. Making a gross pension payment equal to the £3,730 excess (which would cost you £2,984 as 20% relief is applied upfront) extends your basic-rate tax band by an equivalent amount, thus swerving a 40% tax bill. For maximum tax efficiency, make sure you stay within the 20% band when you take the money out.

Not only that, but you will also retain your £1,000 savings allowance, instead of seeing it halve to £500.

A note of caution here: if you’ve made a flexible and taxable withdrawal from your pensions, the amount you can contribute and get upfront tax relief drops to £10,000, under the money purchase annual allowance (MPAA).

9) Plan as a couple

As flagged further up, the progressive nature of the UK’s income tax regime means rates jack up as your income rises. The first £12,570 you earn might be tax free, but HMRC would grab £5,048 (40%) if you earned £12,570 above £50,270.

This is why it pays to team up with a spouse or civil partner if possible as you get two personal allowances and basic-rate bands. This is an extreme example, but a couple where both receive £30,000 a year will be £375 a month better off after tax than another where one partner receives £60,000 and the other nothing.

What’s more, couples can double up on savings, CGT and dividend exemptions and can transfer investments to one another without triggering CGT or inheritance tax (IHT).

10) Speaking of IHT, don’t forget about it

The government’s decision to bring unused pensions into the IHT net from April 2027 has jammed a spanner in the gears of many people’s retirement withdrawal strategies. Before then, the standard guidance was to draw ISA money before pensions, largely to harness the latter’s IHT exemption. But the possibility of punishing combined tax rates if death occurs after age 75 has triggered many investors to swap the order.

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That said, pensions’ IHT exemption wasn’t the sole reason to raid your ISA first. The other, as noted above, is that withdrawals are tax free, meaning you can take less from your portfolio to fund your outgoings.

The big question for retirees will be whether to prioritise reducing their current income tax bill or mitigate loved ones’ IHT liabilities. The answer isn’t the same for everyone, and hinges on your personal circumstances, tax position and estate planning goals. Getting professional advice here can guide you towards the right choice.