How retirees can tame the punishing stealth tax grab

Stealth taxes are meant to chip away at our finances without us really noticing, but the widespread and harmful effects of fiscal drag are becoming increasingly conspicuous.

Tax thresholds have been frozen since 2021-22 and will remain at current levels until 2028-29. As our incomes rise during this seven-year stretch, more of us will unwittingly trip into higher tax bands, beefing up government revenues in a covert manner.

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Recent data from HMRC, obtained by wealth manager Quilter, found that this is expected to impact nearly 32 million people by 2027-28 – a startling figure.

This comprises almost 18 million dragged into the tax net, a further 12 million to start paying 40% tax, and two million more tripping above the 45% threshold, which kicks in when earnings exceed £125,140. The table below shows how the number of people caught out speeds up over time.

Source: Quilter.

The £43 billion carrot

Two key reasons explain why fiscal drag is so effective. First, policymakers can parry the inevitable backlash that would come with hiking headline tax rates, which during this parliament may also break an election manifesto promise.

And second, it’s highly lucrative. Figures from the Office for Budget Responsibility (OBR) show that freezing tax thresholds is estimated to raise £42.9 billion in tax by 2027-28 – roughly double what the government currently rakes in from inheritance tax (IHT) and capital gains tax (CGT) combined.

Millions of over 60s set to start paying tax

What raises further eyebrows is that eight million of those set to start paying tax for the first time are over the age of 60 – a group that contains many who’ve packed up work and are living off their accumulated wealth. Whatever they’ve saved at this point needs to last. Paying less tax is a high priority.

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We should note that a key factor here is the recent series of bumper state pension increases, thanks to the triple lock. This mechanism guarantees the state pension uprates annually by the highest of inflation, wages increases or 2.5%. This month’s hike of 4.1% vaulted the full state pension to £11,973, only £600 below the £12,570 personal tax-fee allowance. With this threshold remaining frozen, a couple of years’ modest increases means the state pension will soon become taxable.

But the triple lock’s generosity aside, pensioners on the lowest incomes often need every penny they can get, particularly those who marginally failed to qualify for last year’s winter fuel payments and are set to miss out on future ones.

There are, however, some ways that retirees can mitigate the effect of fiscal drag on their household income. Here are five things to think about.

1) Maximise ISAs where you can

Shuffling as much of your wealth into tax wrappers, notably individual savings accounts (ISA), is a cornerstone of sound financial planning. That’s because you can invest and save up to £20,000 into ISAs ever year and any interest, gains or dividends are tax-free. What’s more, in most cases you can access the money whenever you like, without penalty. This means that no matter how long tax bands stay frozen, this portion of your income or growth will remain out of HMRC’s clutches.

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If you’ve maxed out your ISA, Premium Bonds offer a tax-free alternative. However, there’s no guarantee the prizes you win throughout the year will match what you can get in a savings account even after tax has been deducted.

2) Understand your annual savings and investing exemptions

Just because your savings and investments aren’t sheltered in tax wrappers like ISAs and pensions doesn’t mean that you will pay tax. There are a few handy annual exemptions to provide further protection, but they only go so far.

• Investments: when it comes to your investments, the ones to take advantage of are the capital gains tax (CGT) allowance and dividend allowance. The former shields the first £3,000 in profits from the taxman, while the latter allows you to earn £500 dividends a year, tax free. Splitting assets between a spouse or civil partner can double up these exemptions.
• Savings: the savings allowance enables 20% taxpayers to earn £1,000 in interest every year, tax free. The figure drops to £500 for 40% taxpayers and if you earn more than £125,140, there is no allowance – you pay tax on all your savings.Therefore, if a basic-rate taxpayer shopped around and found an account paying 5% a year, interest on the first £20,000 will be tax free. Again, shuffling money around between spouses or civil partners, especially if one is in a lower tax bracket, can be shrewd move. That’s because not only could you get an extra allowance, but it could also be bigger, and any tax charged for exceeding it more lenient. But those on the lowest incomes can potentially get five times this allowance. The starting savings rate, as it’s known, enables anyone earning £12,570 or less to earn £5,000 in interest annually and pay no tax.For those who earn more than this figure, a taper applies. Every £1 of other income above £12,570 reduces your starting rate for savings by £1, meaning your savings allowance drops to £1,000 once income hits £17,570.

3) Stagger your pension tax-free cash withdrawals

The decision to withdraw the maximum tax-free amount from your pension is an easy one to make. Choosing how and when to take this money can be a lot trickier.

With most pensions you can take 25% (capped at £268,275) of your total funds tax free. The temptation might be the draw the lot in one hit, and if you’ve got plans to spend and enjoy money, or have outstanding debt, this can be a sensible thing to do.

But if you already have sufficient cash savings to meet immediate financial goals, a more tax-efficient approach can be to stagger tax-free withdrawals.

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Let’s say you’ve retired early, are yet to claim your state pension and have no other income. You could make a part taxable, part tax-free withdrawals of £16,760 from your pension and keep the lot. That’s because the taxable amount (75%) is within your £12,570 tax-free allowance, while the remaining £4,190 (25%) is tax free.

And if your pension continues to grow, what’s left of your tax-free entitlement could increase over time.

This explains why retirement income products such as self-invested personal pensions (SIPP) are so popular. They offer the flexibility to draw from your pension in the way that suits you best at any given time.

4) Use your marriage allowance

If you’re married or in civil partnership, something handy that can put a few extra quid in your household coffers is the marriage allowance.

A spouse who has little-to-no taxable income can transfer £1,260 (10%) of their £12,570 tax-free allowance to their better half, provided they earn less than £50,270.

This can save you an additional £252 in tax, which won’t make you rich, but for spending just a few minutes filling out an outline application form, it’s worth the hassle.

5) Defer your state pension (but watch out here)

Most people will naturally claim their state pension as soon as they can, which is currently age 66 but rising to 67 between 2026 and 2028. You’ve paid sufficient national insurance contributions (NICs) during your working life; it’s time to reap the rewards.

However, did you know you can postpone your state pension and there can be financial advantages to doing so?

If you reached state pension age on or after 6 April 2016, the amount increases by the equivalent of 1% for every nine weeks you defer, totalling 5.8% for every year. Given the current full state amount, this could equate to an extra £694.43 in 12 months’ time, on top of any increase applied by the triple lock.

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This approach might suit those who are still receiving a working income, which could result in a large portion of their state pension being swallowed up in tax.

However, you do need to watch out here, as you would forfeit a year’s state pension payment, which unless you live for around a couple of decades, could mean you were better off claiming it as soon as you could.