He also reminded savers that, under the current rules, most people can normally access their defined contribution pension from the age of 55, although the normal minimum pension age is due to rise to 57 from April 2028.
The 25% tax-free rule isn’t as simple as many people think
One of the biggest misconceptions is that you can simply withdraw the tax-free portion of your pension while leaving the rest untouched.
Martin says that’s not usually what happens.
To explain it, he used one of his trademark analogies.
“I always use a Swiss roll for this analogy,” he told listeners.
He said to imagine the sponge represents the taxable part of your pension, while the jam filling represents the tax-free element.
“If you take a slice, that’s exactly what happens. You might take 25% of your pension, but 75% of what you’ve sliced off is going to be taxed and 25% will be tax-free.”
In other words, simply withdrawing money from your pension doesn’t normally mean every pound you receive is tax-free.
Instead, each withdrawal is usually made up of 25% tax-free cash and 75% taxable income.
Is there a way to take only the tax-free cash?
Martin explained there is.
He’s previously said: “You can take your whole 25% tax-free lump sum if you put the rest in income drawdown, which is an investment product you can take money out of when you need to, or an annuity, which pays you a set income each year for the rest of your life.
“Now the reason this is important is it splits up the tax-free – the jam – from the sponge that’s taxed. I’m pushing the analogy but go with me. This is the reason that counts. Let’s say you’re a higher-rate taxpayer now – if you use the Swiss roll system and take the money out you’d be paying 40% tax on all the taxed amount, but later on in your life you might drop to being a basic-rate taxpayer as you’re earning less.
“So using the alternative route you take the 25% now and you wait to take the taxed amount until you’re a lower-rate taxpayer, so it’s more tax-efficient – you’re paying less tax on the sponge.”
Remember the tax implications
Martin also reminded listeners that although 25% of eligible pension withdrawals can usually be taken tax-free, the remaining 75% is treated as income.
He said: “The rest is taxed at your marginal tax rate… unless it pushes you into an even higher threshold, because it’s like income.”
That means taking a large lump sum in one tax year could move some people into a higher Income Tax band.
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Martin Lewis’ free guidance recommendation
Rather than paying immediately for financial advice, Martin urged people to start with the Government-backed Pension Wise service.
He said: “Anybody taking money from your pension, you should always talk to them first.”
Pension Wise offers free, impartial guidance for people approaching retirement, explaining the different ways to access a pension and the tax implications of each option.
Martin stressed that while advisers at Pension Wise won’t recommend specific financial products, they can help people understand their choices before making what could be one of the biggest financial decisions of their lives.
He concluded with a stark warning: “The mistakes you can make can cost you tens of thousands of pounds… you should always get that one-on-one guidance.”
