Martin Lewis warns pensioners not to fall into 'huge' tax trap when withdrawing money

Martin Lewis has issued fresh warning to retirees pondering the best way to withdraw their hard-earned cash.

On a fresh instalment of his Martin Lewis Podcast, the money-saving maestro cautioned listeners to consider the broader implications when dipping into their pension pots. He highlighted the complexity surrounding the taxation of pension withdrawals, which can often baffle those looking to access their funds.

Kicking off the show, Martin delved into strategies for dodging the "huge pension withdrawal tax trap" and emphasised the importance of viewing pension withdrawals with a long-term perspective. The financial guru underscored the need for careful deliberation on the optimal timing for pension access.

Martin said: "Now the big thing to understand when it comes to taking your money out of your pension, and we're not talking here defined benefit schemes where you're getting 20% of your salary for the rest of your life, we're talking when you've got a pot of money built up. A lot of what's worth thinking about is tax.

"So, pension freedom meant you can keep your money in your pension if you like, think of it a bit like a bank account and you can take your money out when you do. Now many people will know, you generally get 25% of the money you take from your pension tax-free and the rest is taxed."

Martin emphasised that the tricky part of withdrawing tax is knowing exactly when it gets taxed. To simplify this for people, he used the analogy of a Swiss roll to distinguish between the taxable and tax-free parts of your withdrawal.

He elaborated: "I want all of you now to imagine, picture it, nice and tasty, a giant Swiss roll - you have your giant Swiss roll, now most of a jam Swiss roll is of course sponge and you've got the luxury jam bit in the middle.

"Well, the sponge is the taxable part of your pension and the jam running through the middle, that's your tax-free amount. Now if you take your money out of your pension using it like a bank account, you get a slice of the Swiss roll and that Swiss roll contains whatever amount you've taken from your pension.

"Twenty five per cent of it is tax-free and 75% of it is taxed at your marginal rate, whatever the income tax rate you are paying at the top, so you might be at 20%, you might be a 40% tax-rate payer. But if you do what's called a drawdown or an annuity...then you can just take the jam, you can take 25% of your pension totally tax-free and you'll pay the rest via the drawdown or the annuity later when you take it."

A drawdown is essentially a method of receiving a pension income post-retirement, allowing your pension pot to potentially continue growing as an investment. Annuity, on the other hand, involves purchasing with some or all of your pension pot that gives you a steady income for life or for an agreed duration.

Martin stated: "So let's think about this, you decide you want to take that tax-free lump sum early, you're a 20% rate taxpayer, well if you just take the money out, 75% of the money that you take out will be taxed at 20% - it might even push you in the higher tax bracket."

"But when you use a drawdown, you can take all the jam out, the 25% tax-free when you want it and the rest, the sponges left for you to take out of the drawdown or the annuity later on when you choose to use it. And this enables you to control when you're paying the tax on your pension pot.

"If you were to take a 25% lump sum now and then later on in your life as your income drops, you become a non-taxpayer, and take the rest out when you're a non-taxpayer, you'll get a 25% lump sum now and you'll take the rest of the money out - even though it's taxable, you won't be taxed because you're a non-taxpayer and that would be better for you."

He wrapped up by stating that the key thing people need to visualise is the 'big picture' of when the funds will be taxed and which portion exactly will be taxed to aid in making the decision that suits them best.