Why the state pension increase may carry a new tax sting

The new state pension looks set to rise by £9.40 a week to £250.70 from April next year.

Following the publication of earnings data in September – which showed that wages (including bonuses) grew by 3.9% in the three months to July – we can now assume that this will be the figure that’s used to uprate next year’s state pension.

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Under the increasingly contentious triple lock, the state pension is guaranteed to rise by the greater of earnings growth, inflation or 2.5%.

While the actual increase won’t be pinned down until the publication of September’s inflation figures in October, experts are agreed it’s highly unlikely to exceed 3.9%.

But, even if we did see an uptick in inflation, that wouldn’t change the most significant element of next year’s state pension hike: for the first time the full payment will exceed the personal allowance, with a portion of it becoming subject to tax.

Rumours are swirling that the government may increase the personal allowance at this year’s Autumn Budget, which would keep the full state pension out of tax territory. However, this is purely speculation at this stage and, until further notice, all income tax thresholds will remain frozen until 2030/31.

How the state pension is becoming taxable

Lots of people think their state pension isn’t taxable. But that’s not strictly true.

The state pension is added to your other income for the year and, if that total figure exceeds the personal allowance, you’ll pay tax on the surplus.

In practice that has meant that if your only income is the state pension, you wouldn’t need to pay any tax. Meanwhile, those retirees that do pay tax on their income wouldn’t see a reduction in their state pension directly because the tax they owe would typically be deducted from their private pension income.

But from April, the full state pension (for people reaching state pension age after 5 April 2016) will pay £13,036 a year, busting the personal allowance which currently stands at £12,570, by £466.

Over the course of a year that would land a basic rate taxpayer with a £93 tax bill just on their state pension.

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The government has repeatedly indicated that people who do not have any income beyond the new state pension, or are on the basic state pension without any increments, should not have to pay the tax.

Just how this would work, however, has not been confirmed.

But Steve Webb, the former pensions minister who is now a partner at consultancy LCP, has warned that any so-called ‘amnesty’ is likely to be plagued with problems, and the firm’s analysis has suggested that just one in 16 pensioners would benefit.

He said: “The government’s plans to address this point are a mess, and likely to benefit only a small fraction of pensioners. They will also create unfairness between different groups of pensioners and between pensioners and low-paid workers, who do not qualify for any exemption.”

The problem of fiscal drag

An estimated 10 million pensioners are now paying income tax, according to HMRC figures – an increase of three million since thresholds were frozen in 2021. And with the freeze scheduled to continue, that number will only continue to grow.

Historically, the personal allowance has comfortably accommodated the full state pension – and more.

For perspective, in 2021 – when the personal allowance was frozen at £12,570 – the full state pension paid £9,339 a year, meaning pensioners could still enjoy more than £3,200 in private pension top ups before they needed to pay any income tax.

Had the personal allowance not been frozen, and continued to increase in line with inflation, it would now stand at £16,070, according to the Institute for Fiscal Studies (IFS). That would let all tax payers – not just pensioners – earn an additional £3,500 in tax-free income each year.

And, under current inflation forecasts, by 2031 the personal allowance would have reached £17,440, providing a further £4,870 in tax-free income.

So, even though the personal allowance hasn’t changed on paper, it is continuing to be cut in real terms.

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Between 2021 and 2026, the IFS puts that reduction at 22%, rising to 30% by 2031.

In 2024, in the Conservative election manifesto, former prime minister Rishi Sunak, proposed the ‘triple lock plus,’ which would see the personal allowance for pensioners rise on the same basis as the state pension. This would effectively mean that the personal allowance for pensioners would never exceed the full state pension.

But, of course, with Labour winning the 2024 General Election, that proposal never saw the light of day.

Roll on two years and Andy Burnham is facing pressure to unfreeze the personal allowance ahead of 2031 in the upcoming Budget. But with fiscal challenges only increasing, any thaw is not looking likely.

More pensioners paying higher rate tax too

Fiscal drag doesn’t just mean more pensioners are paying tax than before. It also means that existing retired taxpayers are paying tax on a greater proportion of their income and, increasingly, at higher rates.

In September, a new freedom of information request from LCP revealed that more than one million pensioners now pay tax at 40% or more – a number that’s doubled in five years.

Mr Webb said: “Many people of working age may have expected that they would be basic rate taxpayers in retirement, but few will have expected to find themselves paying 40% or more out of their pensions in tax. But this is the norm now for over a million pensioners, with the number set to rise further.”

Becoming a higher rate tax payer doesn’t just affect your income tax bill. It will also reduce the amount of savings interest you can earn tax free as well as the rate you’ll pay on any capital gains.

Finding ways to pay less tax in retirement

New Chancellor John Healey will present his first budget on 28 October.

Speculation as to what it will include is rife but, at the moment, there isn’t anything concrete to suggest that the tax headache for pensioners (or workers) will ease.

That means retirees will need to plan for bigger tax bills, while those who are yet to retire may decide to save more to compensate.

But if you have time on your side, or flexibility in your existing retirement income plan, there are ways to keep your income tax down.

• A good starting point is to know your tax bands and understand the points at which you will start paying tax or your tax rate will increase.
• The personal allowance is £12,570
• Basic rate tax (20%) is charged on income between £12,571 and £50,270
• Higher rate tax (40%) is charged on income between £50,271 and £125,140
• Additional rate tax (45%) is charged on income over £125,140 (it was reduced from £150,000 in April 2023)

Note - tax rates and thresholds are different in Scotland.

• Armed with this information you’re in a better position to manage your retirement income (unless you have purchased an annuity). For example, by keeping watch on your withdrawals you can ensure you don’t accidentally become a higher rate tax payer. Couples can also structure their combined income between them, to ensure they each take advantage of their respective allowances. Transferring assets between spouses or civil partners can also reduce a combined tax bill.
• If you don’t spend your 25% tax-free cash at the start of your retirement, you can instead use it to increase your retirement income, without bumping up your tax bill.
• You can also use money saved in individual savings accounts (ISA), to boost your income without increasing the tax you owe, as all withdrawals are tax free. If you’re working, and have a healthy pension already, it may be worth pumping extra spare cash into a stocks and shares ISA to increase your sources of tax-free income when you do eventually retire.
• Talk to a financial planner if you’re not sure what to do. They’ll be able to look at your overall financial picture and help you structure your retirement income in a way that delivers what you need in the most tax-effective way.