Martin Lewis warns of a tax trap that could cost you £10,000s off your pension

The clip above has been taken from The Martin Lewis Money Show, broadcast on Thursday 18 February, courtesy of ITV Studios Ltd, all rights reserved. You can turn on subtitles by selecting the keyboard icon in the bottom right and watch the full episode on the ITV Hub.

Taking money out of your pension can be taxing

Martin explained in the show that there are a couple of ways to withdraw money from your pension pot – but one method is likely to see you charged much more in tax. He used his Swiss roll versus a cake plus a pot of jam analogy to help people understand: 

• Withdraw cash lump sums from your pension (not as tax-efficient). Martin said: "You can leave your money invested in your pension pot, then when you take it out, a quarter of it is tax-free and three-quarters is taxed at your marginal rate – in other words, the highest rate of income tax you're paying at that time.

  "Here's the issue: if you take your money out of your pension, whether you take it all or you take it in bits, you can't say 'I want the 25% tax-free now and I'll take the rest later'. I use a Swiss roll as an analogy – you can have a slice and the jam is tax-free – a quarter of it is tax-free – but three-quarters of it is taxed, and you have to have both.

  "Now the problem with that is, let's say you're taking £20,000 out and you're a basic-rate taxpayer, the three-quarters of that that gets taxed and gets added on top [of any other income you earn] could push you into the higher-rate tax bracket so you're paying thousands you need not do." 

• Opt for pension drawdown (likely to be more tax-efficient). "There is an alternative route", Martin 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."

See our Pension Need-to-Knows guide for further help on pension saving. It's worth pointing out that Martin's show was all about private pensions, which are separate from the state pension. See our State Pension guide for more on how this scheme works.  

Martin used this graphic showing his Swiss roll and sponge cake analogy to explain how pensions are taxed. (Note that the Pensions Advisory Service's webchat is now open 9am-6pm Monday to Friday, not till 10pm.)

Get free one-on-one pension guidance if you're confused

If you're struggling to understand pensions, there's free help available. As a first port of call, you can and should get help from the Pensions Advisory Service. Martin said: "The Pensions Advisory Service is an arm's length Government agency that will give you one-on-one advice."

Remember, there is a clear difference between guidance and advice. Guidance is offered by an impartial service which will help you to identify your options and narrow down your choices but will not tell you what to do or which product to buy; the decision is yours. 

Advice will recommend a specific product or course of action for you to take given your circumstances and financial goals. This will be personal to you, based on information you provide. Read our guide on picking and paying for an independent financial adviser. 

Consider how long you'll live before withdrawing any pension cash

Of course, despite 'pension freedom' rules meaning savers can now access their cash from age 55, Martin warned that you need to try to estimate how much longer you're likely to live for as this will help you to know how much cash you need. 

Martin explained: "When 'pension freedom' first happened, the big newspaper worry was 'people are going to buy Ferraris and have no money for the rest of their life'. My concern was actually the opposite. I think we're quite risk-averse as a nation, so people would be living very low standards of living so they're eking out enough cash for the rest of their life, when they could actually have a better life."

To try to find a balance, you'll need to consider your health, genetics, whether you smoke and your age. Martin points out that a man aged 65 now will live on average for 20 more years, and a woman for 22 more years – so plan your finances that way and don't underestimate how much longer you're likely to live.

Work out how much you should save each year with Martin's trick

Martin also revealed a trick to work out how much you should save into your pension pot each year to live comfortably in retirement. As a rule of thumb, Martin explained: "To get roughly two-thirds of your final salary each year in retirement, you'd need to take the age you start contributing to your pension, halve it and put that percentage of your salary in for the rest of your life."

He used the example of several celebrities, and what they'd need to save each year to get roughly two-thirds of their final salary each year in retirement if they started saving now: 

• Athlete Dina Asher-Smith, 25, would need to save 12.5% each year for the rest of her life.

• Singer and TV presenter Rochelle Humes, 31, would need to save 15.5%. 

• And TV presenter Ben Shephard, 46, would need to save 23%.

But Martin added: "I know what you're thinking – you're doing the equation for yourself and thinking 'there's absolutely no way I can afford that' and you're right. Very few people do.

"The real message I want you to get out of that is that the earlier you start contributing to your pension, the better, as the less of your salary you have to put in. If you know a 20 or 21-year-old, tell them, 'get money in your pension now, even if it's £10 or £20 a month', because it has got time to compound and that'll make you a much better retirement."