Martin Lewis has warned pension savers they could lose £1,000s, or even £10,000s, from their pension by falling foul of a trap that sees withdrawals taxed.

In last week's Martin Lewis Money Show, the money saving expert explained how taking money out of your pension could mean you are taxed on your withdrawals.

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 a Swiss roll versus a cake plus a pot of jam analogy to help people understand.

Lancashire Telegraph:

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.

"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 per cent 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 added, "you can take your whole 25 per cent 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.

"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 per cent 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 per cent 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."

Martin's show was all about private pensions, which are separate from the state pension.

If you're confused:

  • Get free one-on-one pension guidance
  • Consider how long you'll live before withdrawing any pension cash
  • Work out how much you should save each year with Martin's trick