When paying your state pension into a personal pension makes sense

It may feel counterintuitive to even think about putting your state pension into a personal pension or self-invested personal pension (SIPP). After all, it’s paid as a retirement income, and for many older people it forms the backbone of their retirement finances.

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However, there are certain circumstances in which channeling the cash into a pension wrapper can make a lot of sense from a tax perspective. Let’s consider the most obvious scenario first, to see how it works.

State pension age and still earning

If you have reached age 66, you’ll be able to claim your state pension, now worth a maximum £11,502. You may well have stopped working by then and be enjoying a well-earned retirement, with this income stream playing a key or supplementary role in your financial planning.

But an increasing number of people don’t actually need the money at that point, because they are still working part time or even full time at that age.

According to analysis of ONS labour market statistics by the Centre for Ageing Better, more than one in nine people (11.5%) aged 65-plus are still in the UK labour market - double the figure in the year 2000.

Not only will many of these older workers not have touched their private pension income, but they may be keen to continue contributing to their workplace or personal pension as far as they can afford to.

Provided you can live comfortably on your earned income, the state pension (or earnings to that value) could therefore be recycled straight into your private pension.

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According to the rules, each tax year, you’re allowed to pay in up to 100% of your earnings or £60,000 – whichever is the lower value – and receive tax relief on your contributions.

Moreover, as Tom Kimche, head of advice at Netwealth, points out: “You could also consider carrying forward unused allowances from the previous three tax years if you earn more than £60,000.”

It’s worth noting, however, that this arrangement only works until you reach the age of 75, at which point you will stop receiving tax relief on pension contributions.

What are the attractions of using the state pension this way? Well, if you have cash you don’t need to live on at the moment, a pension wrapper is by far the most tax-efficient home for it.

Not only do you get tax relief on your contributions, but the money can be invested and grow free of tax on dividends or capital gains. Additionally, when you do eventually stop working and turn to your pension, you can withdraw 25% free of tax; and unused pension savings are also not subject to inheritance tax (IHT) when you die. In short, the more you’ve been able to pay into your pension shelter, the better.

Kimche makes the important point that many people in this position wouldn’t consider it to be specifically their state pension that is being used in this way.

“They would likely have a current account that the state pension is paid into, along with other income. It might be that conceptually they see themselves as using part of their general cash reserve to fund their pension contribution, rather than the state pension specifically,” he observes.

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However you choose to view the cash, though, it could be a valuable late-stage boost for your retirement pot. “This is a great way of making some additional savings into your pensions,” comments Ian Cook, a chartered financial planner at Quilter Cheviot.

But, he warns: “Be mindful of the lifetime death benefit allowance which kicks in on pensions worth more than £1,073,100.”

This recently introduced change to the pension rules replaces the old lifetime allowance, which capped the amount that could be saved before a hefty tax penalty was triggered. That no longer applies, but on your death the ultimate beneficiary of the remaining pension pot may pay 40% or 45% to receive it.

“Every situation needs to be looked at individually, as it may be better to pay some tax now and gift those monies,” adds Cook.

Still working beyond state pension age, but have accessed pension income

Once you reach the age of 55, you’re allowed to access your pension savings; you might decide to do so if you have a period out of work, for example, or want to cut back your working hours because of caring responsibilities or health worries.

If you withdraw only tax-free cash, then as and when you are in a position to do so, you can continue to contribute up to the full annual allowance into your pension pot each year.

But if you start to take taxable pension income using drawdown, you automatically trigger a much lower annual contribution limit called the money purchase annual allowance (MPAA). Once this is activated, the annual maximum gross contribution you can make to your pension falls to £10,000 (or your annual income if you earn less than that).

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If you’re still in paid employment but have triggered the MPAA, then, you can still use your state pension to take advantage of that reduced allowance. However, Cook warns that HMRC has rules in place around so-called pension recycling, so it’s a good idea to take advice if you’re still drawing pension income while working.

Drawing state pension and no longer earning

Anyone, even a pensioner with an income below the income tax personal allowance of £12,570 for the 2024-25 tax year (perhaps because they are supplementing their state pension with tax-free ISA proceeds), can fund a stakeholder pension up to £3,600 gross.

Even though they don’t pay tax, they will receive tax relief on the contributions (so they’ll be paying in up to £2,880, to which the government adds a further 25%), and can draw the money straight out as income if need be, or invest it and leave it to grow.

As Kimche notes: “Most people in a position to pay their state pension into a personal pension will have stopped working by state pension age, so they will be limited to contributing £3,600 gross each year. Nonetheless, it’s worth doing!”

Particularly for those who are still earning and making pension contributions beyond state pension age, redirecting state pension in this way can be a great way to maximise the tax benefits of retirement savings.