Martin Lewis has issued his latest advice for pensioners looking to withdraw money, warning them of a ‘tax trap’.

In the latest episode of his Martin Lewis Podcast spin-off, he warned people to look at the bigger picture when taking money out of their pension. One of the main things that can confuse many retirees is how exactly the money they take out will be taxed.

Earlier in the show, he explained that the advice is for pension funds to avoid the “huge tax trap of pension withdrawals”, and how to look at their pension withdrawals in the long term. The personal finance champion also advised thinking carefully about when is the best time to withdraw your pension.

Martin explained: “The most important thing to understand when it comes to taking your money out of your pension, and we’re not talking about defined benefit schemes where you get 20% of your salary for the rest of your life, we’re talking about when you’ve built up a pot of money. A lot of what’s worth thinking about is tax.

“So, pension freedom meant that you could leave your money in your pension if you wanted to, think of it a bit like a bank account and you could withdraw your money if you wanted to. Now a lot of people will know that generally speaking you get 25% of the money you take out of your pension tax free and the rest is taxed.”

Martin emphasized that the tricky part about tax withdrawals is understanding when exactly tax is levied. To make it easier for people, he used the example of a Swiss roll to differentiate between what portion of your withdrawal is taxable and what portion is tax-free.

He added: “I want you all to imagine now, imagine, a lovely big Swiss roll – you’ve got your big Swiss roll, but the main part of the Swiss roll with jam is of course cake and you’ve got the luxurious jam part in the middle.

“Well, the sponge is the taxable part of your pension and the jam that runs through the middle, that’s your tax-free amount. Now, when you take your money out of your pension and use it as a bank account, you get a piece of the Swiss roll and that Swiss roll contains the amount that you took out of your pension.

“Twenty-five percent of that is tax free and 75% of that is taxed at your marginal rate, whatever income tax rate you pay at the beginning, so you can pay 20%, you can be a 40% taxpayer. But if you do what’s called a withdrawal or an annuity… then you can just take the jam, you can take 25% of your pension completely tax free and you pay the rest later through the withdrawal or the annuity when you take it.”

A drawdown is essentially a way to get a pension income after retirement, while still allowing the pension fund to potentially grow as part of an investment. Meanwhile, an annuity is something that is purchased with some or all of your pension pot, which then allows you to receive an income for the rest of your life or for an agreed number of years.

Martin added: “Let’s think about it. Say you decide to withdraw that tax-free amount early and you pay 20% tax, then 75% of the amount withdrawn is taxed at 20%. That might actually put you in a higher tax bracket.

“But if you use a withdrawal, you can take all the jam out, the 25% tax-free when you want and the rest, the sponge, is left to take out later from the withdrawal or the annuity when you choose to use it. And this allows you to determine when you pay tax on your pension pot.

“If you were to take a lump sum of 25% now and later in life, when your income goes down and you don’t have to pay taxes anymore, and you take the rest when you don’t have to pay taxes anymore, then you get a lump sum of 25% now and you take the rest of the money out. Even though it’s taxable, you don’t pay any taxes because you don’t have to pay taxes anymore. That would be better for you.”

He concluded that the most important thing is for people to understand the ‘bigger picture’ – when the money will be taxed and exactly what portion will be taxed – so they can make the decision that is right for them.