5 key tax issues for pensioners in 2025-26

Recent figures from HM Revenue & Customs (HMRC) indicate that there were more than seven million taxpayers of pension age in 2022-23.

This number is certain to have increased in the past two years, with more people now having to deal with the taxman after they stop working.

Ahead of the 2025-26 tax year starting on 6 April, we take a look at five pitfalls and key considerations that retirees will need to keep in mind.

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1. The effect of frozen tax thresholds

The number of pensioners paying tax will rise further as the state pension and general retiree incomes increase while income tax thresholds remain frozen. This is known as fiscal drag. 

The current thresholds of £12,570 (above which you pay basic-rate tax of 20%) and £50,270 (where the higher rate of 40% begins) have been frozen since 2022. From 2028-29, thresholds will be increased in line with inflation.

In 2022-23, the full rate of the new state pension was worth £9,628 per year, which used up around 77% of the £12,570 personal allowance. For 2025-26, the state pension has risen to £11,973, or 95% of the personal allowance.

This is why an increasing number of pensioners are now having to pay income tax. If the thresholds had risen in line with inflation since 2022, the personal allowance would now be £15,220, and the higher-rate threshold would be £61,020.

• Find out more: how much is the state pension?

2. Drawing down your funds sensibly

The state pension will provide a fixed income in any tax year. Beyond that, particularly if your pension funds are in drawdown, you’ll need to control your level of withdrawals so more money doesn’t end up subject to tax. The same problem applies if you are cashing in entire pensions. 

Managing pension drawdown in a tax-efficient way has become increasingly tricky with the freezing of income tax thresholds. If you want to take a big amount from your drawdown scheme, perhaps more than £50,000, you’ll end up paying 40% tax on some of it. 

Money paid out under drawdown is taxed as pension income under pay-as-you-earn (PAYE) in the year of payment. This could be taxed at 20%, 40% or 45% (for income over £125,140).

The key to making the money last is only drawing what is needed, carrying out regular reviews and navigating the tax allowances available and tax bands to ensure that your bill isn’t higher than it needs to be. 

• Find out more: pension drawdown calculator – making your money last

3. Tax-free lump sums

Speculation about the long-term future of the tax-free lump sum, officially known as the pension commencement lump sum (PCLS), intensifies whenever there is a Budget or fiscal statement. 

It would be relatively easy for the Chancellor to raise money by reducing this tax-efficient option. However, it appears safe for now. 

You can usually take up to 25% of your pension pots without needing to pay any tax (the PCLS). The maximum tax-free lump sum (the lump sum allowance) is capped at £268,275 for the majority of people. 

While the continued availability of the PCLS is generally a good thing for retirement savers, taking the tax-free cash isn’t a straightforward decision.

Money you leave in your pension should continue to benefit from investment growth. Plus, taking a big chunk at the outset might make it harder to make the money last throughout your retirement. The change in inheritance tax rules around pensions is another factor to consider – as we'll explain next.

• Find out more: can I take a lump sum from my pension?

4. The spectre of inheritance tax

Pensioners will already be thinking about ways to minimise a potential inheritance tax (IHT) bill for their estate, ahead of new rules set to come into force in 2027.

The final details are yet to be confirmed, but money left in a defined contribution (DC) pension after your death, whether a workplace or personal pension, will be counted as part of your estate for inheritance tax purposes from April 2027.

There will still be a tax-free allowance of £325,000 (the nil-rate band) and an extra allowance worth up to £175,000 (residence nil-rate band) if you leave your main home to your children or grandchildren. Unused allowances can be inherited by your spouse, boosting the potential tax-free amount to £1m.

The new rules will also apply if you’ve already started taking an income from your DC pension via drawdown or uncrystallised funds pension lump sums (UFPLS) and have unused funds.

Different approaches will need to be taken to ensure that your pension funds don’t go to the taxman. The most obvious one is to spend more of your retirement savings rather than aim to pass them on.

Giving money away during your lifetime, from your pensions or other assets, can help to reduce the tax bill your loved ones could face when you die. There are limits to how much you can give away tax-free – the main one being your annual exemption of £3,000.

Gifts you make that fall outside of the set gifting limits become what are known as potentially exempt transfers (PETs). These fall out of your estate after seven years have passed. If you die before then, the gifts could end up being taxable.

• Find out more: inheritance tax: thresholds, rates and who pays

5. Tax should become less taxing

It’s always nice to end with a piece of good news. 

HMRC has announced that from April 2025, it will end the practice of overtaxing first pension withdrawals for some savers. At present, people have to claim back overpayments from HMRC or wait until the end of the tax year to get the money back.

Since 2015, HMRC has taken extra tax on initial drawdown withdrawals. The first payment will often be taxed using an emergency tax code on a ‘month one’ basis – assuming it is the first of a number of withdrawals over the rest of the tax year.

HMRC plans to move more quickly to replace emergency tax codes with regular tax codes. This will ensure that the correct amount of tax is deducted in real-time. It will assist those taking regular income from pension drawdown but not savers taking lump sums. 

HMRC explained the change in a newsletter in January 2025. It wrote: ‘From April 2025, we are improving how tax code information is used for those people who are new to receiving a private pension, so they pay the right amount of tax from the outset. 

'We will automatically update the tax code for customers who are on a temporary tax code and would benefit from being on a cumulative code. This means they'll avoid an overpayment or underpayment at the end of the year.’