Tax trap hits thousands raiding retirement pots - how to beat it

Thousands of savers have been hit with eye-watering tax bills, some in excess of £60,000, after draining their pensions in one go, despite warnings that the heavy costs could be avoided with better planning.

New analysis by Standard Life, based on data from the Financial Conduct Authority, reveals that nearly 1,600 people fully emptied their pension pots-each worth between £100,000 and £249,000-between October 2023 and March 2024.

Each of these individuals is estimated to have paid at least £27,400 in tax, with many forking out far more. Those drawing the average pot of £174,500 are likely to have handed over about £64,700 to HMRC, according to the insurer's calculations.

That figure is rising, too. The lowering of the additional rate tax threshold-from £150,000 to £125,140 in April 2023-means those taking lump sums are being dragged into the top tax bracket more easily, worsening the hit.

Adding to the alarm, a further 292 individuals cashed in pension pots exceeding £250,000, landing themselves with tax bills of at least £98,700. That's around £1,200 more in tax than they would have paid just a year earlier.

Experts say many of these painful tax bills could have been significantly reduced-or even largely avoided-by spreading withdrawals over time.

Mike Ambery, Retirement Savings Director at Standard Life, part of the Phoenix Group, said: "A huge number of people are paying a disproportionate amount of tax to access their pension.

"It's impossible to know whether their individual circumstances warranted them taking such a big tax hit, but for the vast majority of people it's something they'll want to avoid."

He added: "While some people want to withdraw their entire pension and put it in their bank account for ease of access, this can be financially detrimental.

"Not only does this mean their savings become eligible for tax but it also means they're potentially giving up investment returns."

The way HMRC treats pension withdrawals is central to the issue. Only the first 25% is tax-free. The rest is treated as income and taxed under normal income tax rules. That pushes many into higher tax brackets, meaning savers could lose tens of thousands in a single transaction.

Despite this, many remain unaware of the risks. Financial advisers and pension firms have long argued the tax system encourages gradual withdrawals and penalises lump sum access.

Mr Ambery outlined a more efficient strategy for retirees looking to avoid handing a large slice of their savings to the taxman.

"The simplest way to avoid paying too much tax is to make sure you don't take any more from a pension pot than you need to. Taking it in small, regular chunks could keep your tax bill down," he said.

He suggested a method combining taxable and tax-free elements. Specifically, by taking £1,000 a month from the taxable portion-below the £12,570 personal allowance-and another £1,000 from the tax-free element, retirees could generate £2,000 in monthly income without triggering income tax.

He also pointed to the benefit of using ISA savings to help manage expenses without incurring tax.

"Unlike your pension pots, the savings in your ISA generally won't be taxed at all when you take them," he explained.

Financial experts are urging savers to seek advice before tapping their pensions, especially as retirement incomes are increasingly expected to last 20 to 30 years.