The pension freedoms allow individuals over the age of 55 the chance to withdraw any amount from their personal, stakeholder and some workplace pensions: the first 25% lump sum withdrawal is tax-free while the remainder will be subject to income tax at the individual’s highest marginal rate.

Spring Budget documents revealed the Treasury netted £2.6bn of tax from the heralded pension freedoms which came into effect in April 2015, much more than the projected estimate of £920m.

Further, the Treasury expects to receive £5.1bn by April 2019 ahead of the initial £3bn projection.

The data echoes Hargreaves Lansdown’s July 2015 prediction that the government’s tax take from the pension reforms would be significantly higher than originally forecast.

Since launch, the reforms have proven popular with those aged 55+ and Richard Parkin, head of pensions policy at Fidelity International, said pension freedoms are clearly benefitting the government too.

“In many cases this is just bringing forward to today tax that would have been paid in the future but it’s clear that the rush to get cash out is having people pay more tax than they need to.

“Before accessing pension savings people should consider whether they really need the money. It might feel more accessible in a bank account but it could have a significant cost in terms of lost returns and tax. Where people do need to access their pensions they should consider doing that in a way that minimises tax by spreading withdrawals. So think carefully before withdrawing monies and if in doubt, seek expert help as the decisions you take here cannot be undone.”

Below, Parkin outlines five tax mistakes consumers often make and offers solutions to keep more of your retirement savings.

Pension freedoms tax mistakes to avoid

1) Taking a large taxable withdrawal and paying more tax than you need to

There are three reasons the Treasury’s done so well: more people have accessed their money than expected, they’ve done it sooner and they’ve paid tax at a higher rate than expected.

When cashing in a pension pot, any taxable element is treated as income in the tax year that it is taken. A £30,000 earner cashing in a £30,000 pot would end up paying a total tax bill of £6,400.

Here are the step-by-step calculations:

• The first 25% or £7,500 is tax-free
• The remaining £22,500 would be added to the £30,000 earnings (a total of £52,500).
• Here, the individual would pay the higher 40% rate tax on £9,500 (the amount over the £43,000 higher rate tax threshold), totalling £3,800.
• They would also be taxed 20% on the remaining £13,000 (remaining £22,500 pension withdrawal minus the £9,500 of taxed income).

If they’d taken half the pot this year and half next, each payment would give £3,750 of tax-free cash, plus £11,250 of taxable income. As such, the total income would come to £41,250 – below the higher rate tax threshold so they’d only be charged 20% tax of £2,250 on each amount, so a total of £4,500. Withdrawing the cash in this way would save the individual £1,900 in tax.

2) Taking tax free cash and putting it in the bank

Many people access their pension with a specific purpose in mind, but a significant number just put the money in a bank account. This creates several tax issues as once in the bank any returns are subject to tax (subject to the Personal Savings Allowance), and any bank deposits also count towards your estate for inheritance tax (IHT) purposes and it can impact entitlement to certain state benefits. Pensions are not included in IHT. On death they are either completely tax-free if the individual dies before age 75, or taxed as income in the hands of the beneficiary when they draw the benefit.

3) Taking tax-free cash all at once

It may be tempting, but many people misunderstand that you don’t have to take your tax-free cash all at once. You can stagger this and take out bits of your entitlement at a time. This ultimately means leaving more invested and growing more tax-free cash for the future. Here are some examples:

• Mrs A earns £5,000 from a part-time job and cashes in a £15,000 pot. She would pay tax of £1,050, but if she spread the payment over two years she’d be under the personal allowance and so pay no tax at all.
• Mr B earns £50,000 and cashes in a £50,000 pot. He pays tax on £37,500 at 40% giving him a tax bill of £15,000. As he’s already a higher rate tax payer, he’s not able to reduce his tax bill by phasing withdrawals.
• Miss C earns £80,000 and cashes in a £50,000 pot. This gives £37,500 of additional income taxed at 40%, but now her total income is £117,500 meaning she loses £8,750 of her personal allowance, which then effectively gets taxed at 40% giving her an additional tax bill of £18,500. If she’d taken it as two payments of £25,000 (£18,750 of each taxable) she’d be under the £100,000 limit for losing personal allowance and would have paid total tax of £15,000 saving herself £3,500.

4) Taking tax free cash when you don’t pay tax 

With the current personal income tax allowance at £11,500 for 2017/18, it may not make sense to take cash if you don’t use up your allowance.

For example, if someone has £6,000 of unused personal allowance they could take £8,000 from their pension plan and pay no tax (25% is tax-free leaving £6,000 as taxable). An important point to note is that limits what you can put back in your pension. From April 2017, the Money Purchase Annual Allowance limit of £10,000 will fall to £4,000 per year.

5) Taking tax free cash but taking the incorrect amount

If you were in a pension scheme before 2006 you may be able to take advantage of what is called protected tax-free cash. The rules are quite complex but could mean you’re entitled to more than 25% of your pension savings as tax-free cash. You should check with your pension plan provider to see if you’re eligible. If you are,you will probably need to provide earnings details from before 2006 to allow the pension provider to calculate what you’re due.