How the 2024 Budget will affect pensioners

Last week’s Spring Budget may not have been the pre-election, tax-slashing event that Jeremy Hunt so desperately wanted, but it’s given us plenty to chew on. Perhaps none more so than the impact on pensioners, which has not flown under the radar.

In response to the Budget, former pensions minister Steve Webb tweeted: “Repeated cuts to [national insurance] NI rates with no changes to pensions highlight the fact that the National Insurance Fund is a complete work of fiction.”

Webb, now a partner at consultancy LCP, was referring to the current system where national insurance contributions (NICs) paid by today’s workers are used to pay the state pensions of today’s retirees.

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But as Webb notes, the government’s move to cut NICs for both employed and self-employed workers at two set-piece fiscal events on the bounce has cast doubt on whether this truly reflects how the National Insurance Fund works.

The heavy NIC reductions mean less money going into the pot – a pot we’re led to believe is becoming increasingly light due to the combination of a swelling retirement population and shrinking labour force. If the state pension is to remain affordable, alternative funding will surely be needed?

The Budget raised other big questions, too. The chancellor hinted that NI is edging towards the scrap heap, with a single tax on income apparently in the pipeline.

We must also consider the impact of fiscal drag on pensioners, as the government chose to keep tax thresholds frozen from April. New research suggests that will result in more than a million pensioners paying tax on income in the next few years.

So, let’s unpack how the Budget may impact those above state retirement age.

Will income tax and NI be merged into a single tax?

Most of us are aware that NI is a tax, even though it isn’t labelled as such. And a very bright light has been shone on NI’s role in the tax system in recent months.

The International Longevity Centre (ILC) claimed last month that the UK should hike the state pension age to 71 by 2050 to ensure it remains sustainable. On that basis, if the state pension is truly funded by NICs, increasing rates rather than cutting them seems the only logical solution.

The reductions to NI have been far from conservative. Employee Class 1 NICs and Class 4 NICs will both be a third lower from April, while Class 2 – a fixed amount paid by self-employed workers – will be scrapped.

Interestingly, Class 2 enables the self-employed to build state pension entitlement, although this will no longer be the case from April. The cuts to NI are set to cost the government around £20 billion a year.

Given the similarities between income tax and NI, the prospect of merging the two has been mooted. Hunt indicated a desire to abolish NI, both during his Budget speech and afterwards, and move towards a single tax on income. The chancellor argues this will make things simpler and fairer.

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As I noted in an article earlier this month, the Institute for Fiscal Studies (IFS) published a paper a few years ago and found a strong case for amalgamating the two taxes. The IFS claimed that successive governments have poured cold water on the idea. However, Hunt’s recent comments suggest ministers have changed their stance.

As the IFS stressed, this would not be cheap. The Labour Party reckons it could cost £46 billion a year – or £230 billion over a five-year Parliament.

If income tax and NI are eventually brought under one roof, the current state pension funding system would need a complete makeover. In addition, it seems inevitable that income tax rates will rise to plug the void left by NI. This could penalise retirees as they don’t pay NI, as I explain below.

Is the UK tax system fair for pensioners?

While workers will see a boost to their pay packets or profits because of the NICs cuts, pensioners won’t see any benefit.

That’s because you stop paying NI once you hit state retirement age – currently 66 but rising to 67 in 2028 – whether you’re still working or not.

In every Budget there are, of course, winners and losers. It’s very rare that tax cuts are cheered by all sections of society. But over the past 10 years pensioners have disproportionately found themselves on the losing side, according to Paul Johnson, director at the IFS.

After the Budget was announced, Johnson tweeted: “Counter [to] the narrative that pensioners always win. A worker on £25k has seen big direct tax cuts since 2010, pensioner on the same income has seen taxes rise.”

IFS data shows that in the 2010-11 tax year, an employee earning £25,000 a year paid just under £5,000 in personal taxes, while a pensioner on the same income paid roughly £2,000.

However, from the 2024-25 tax year, the gap will have narrowed significantly: a pensioner on £25,000 will face a tax bill of around £2,500 a year, while a worker will pay around £3,500 – a £2,000 swing.

Put simply, workers have gained from Budget tax changes during this period, while pensioners have lost out. And this doesn’t just apply to those on modest incomes. IFS research found that a pensioner earning £75,000 will pay around £2,500 a year more in tax next year compared to 2010-11, while a worker will pay around £1,000 less.

Full state pension hurtling towards personal allowance

On a brighter note, pensioners will receive an income boost in April with the state pension set for a hefty 8.5% rise.

This is thanks to the triple lock, a policy that has been subject to constant scrutiny, with critics flagging concerns about its sustainability. As a reminder, the triple lock guarantees the state pension rises every year by the higher of inflation, average wage increase or 2.5%.

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The state pension was hiked 10.1% last April due to 40-year high inflation in 2022 and will rise above £11,500 a year next month as a result of soaring wage increases in the middle of last year. We must note that those who retired before April 2016 are on a different system, and many will only get £8,812 a year.

While the bumper increase has been warmly welcomed by pensioners, especially those on the lowest incomes, there is another factor at play that will temper its impact.

The decision to freeze income tax thresholds at their current levels until 2028 means the gap between the state pension and the personal allowance - the amount you can earn before paying tax – is narrowing significantly. .

As the table shows, between 2016 and 2020, the gap widened every year, and by a reasonable margin.

The peak occurred in 2019-20, when the margin stood at £3,732. This meant that a fair chunk of other pension income – either from drawdown withdrawals, an annuity, or defined benefit (DB) – escaped tax.

But ever since, the difference has shrunk, with things really speeding up in the past two tax years, falling from £2,952.20 in 2022-23 to just over £1,000 from April.

One may argue that the generosity of the triple lock is the key reason behind this trend. But frozen tax bands are playing an equal, if not bigger, role.

Given that the personal allowance is set to remain at £12,570 until 2027-28, even a few years of moderate increases will see the state pension trip into tax-paying territory. This could mean that pensioners will pay tax on all income they receive outside tax wrappers and any interest above the £1,000 personal savings allowance. What's more, analysis by the House of Commons for the Liberal Democrats calculates that an extra 1.6 million pensioners will pay tax in the next four years.

And this comes at a time when the cost of living comfortably in retirement has vaulted in recent years.

According to figures by the Pensions and Lifetime Savings Association (PLSA), in the 2021-22 tax year, £30,600 a year was enough for a couple to live a moderate lifestyle, but this figure has since jumped to £43,100 – a huge 41% uptick.

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The increased cost of goods and services isn’t the only reason for such a striking increase, but it’s a significant one. And importantly, the figures shown are after tax has been deducted. The higher proportion of income pensioners lose to HMRC, the less they’ll have to fund their retirement lifestyles.

What’s more, once the state pension catches up with the personal allowance, any further state pension hikes will be smaller in net terms, as 20% will be wiped off in income tax.

We must recognise that frozen tax bands are affecting workers too - although this will be offset, in the short term at least, by the NIC cuts.

Pensioners will have to be content with just the state pension increase from April. The good news is it’s a healthy boost. However, in the long term, the question of how they will be taxed and how their pensions will be funded has become more uncertain since the chancellor sat down just after 1:30pm on 6 March.