Winter fuel payment U-turn and the new tax cliff edge

The government’s U-turn on the winter fuel allowance was, in many people’s eyes, a welcome move.

Prime Minister Keir Starmer and Chancellor Rachel Reeves had faced mounting pressure from voters, opposition parties and trade unions to row back on its decision to axe the payment for pensioners not in receipt of certain income-related benefits, such as pension credit.

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Critics argued that more lower-income pensioners, particularly those who only marginally fail to qualify for pension credit, should receive the allowance to help foot the cost of heating their homes during colder months.

Explaining the government’s change of heart, Rachel Reeves said: “Targeting Winter Fuel Payments was a tough decision, but the right decision because of the inheritance we had been left by the previous government. It is also right that we continue to means-test this payment so that it is targeted and fair, rather than restoring eligibility to everyone including the wealthiest.”

Under the new means-tested system, every household in England and Wales with someone above state pension age will receive the payment – which is £200, or £300 where someone is aged 80 or over – but pensioners with taxable incomes above £35,000 won’t keep it (more on that further down).

The government reckons the change will cost around £1.25 billion, while the means-testing element will save around £450 million. Presumably the fiscal hole it creates – which is not enormous but not insignificant, either – will need to be plugged elsewhere. Considering the government is already under pressure to meet its narrow, self-imposed fiscal rules, the rumour mill has already started spinning, with speculation about tax rises at the Autumn Budget.

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The upshot under the new change is that nine million of the 11 million pensioner population will receive and retain the allowance, and it should avoid a repeat of last winter’s pension credit application frenzy.

So, problem solved, and the debate can now be put to rest? Well, not quite.

Critics of the revised regime have emerged, flagging several concerns. The first, they say, is that it will lead to many better-off pensioners resuming receipt of an extra three-figure sum every winter that they don’t need.

A second sticking point, detractors’ claim, is that it makes things rather messy, and in some cases potentially unfair. In a similar vein to the child benefit system, households with a high combined income might be entitled to some winter fuel payments, while those with less may forfeit them. As the government notes: “The payment will be recovered from individuals via HMRC based on their individual taxable incomes. There will be no need for household incomes to be aggregated.”

Paul Johnson, director at the Institute for Fiscal Studies (IFS), wrote on social media site, X: “WFP [winter fuel payment] will now be paid at £100 to each member of a couple. So rich pensioner couples, where one has say £100k and the other £30k, will still get £100. If both members of [the] couple have £36k then they will get nothing. Messy.”

If your income exceeds the £35,000 threshold, the allowance – or your share of it – will be clawed back via PAYE or via self-assessment.

A third sticking point is that Labour appear to have created a brand-new tax cliff edge – like the one concerning childcare, although not as extreme. From what we can gather, and as Johnson suggests, if your pre-tax income is £35,000, you’ll retain the full payment, but if you pocket a pound more, you’ll lose it. While anyone who earns £35,000 in retirement, which is just shy of the UK average wage, may consider themselves financially stable, few would want to forgo the allowance if they don’t have to – especially now that energy prices are surging up again.

Effective tax rates under new cliff edge

Let’s look at the effective tax rates this may create for one-person households.

Over age 80

Under age 80

As the winter fuel payment is paid as a single lump sum - and is clawed back in full if income surpasses £35,000 - the effective tax rate for exceeding threshold reduces as income rises. The effective tax rate will also be lower if you’re in a two-person household where one individual’s income is above £35,000 but the other’s is below, as only half the payment is recouped.

A further consideration is that unless the threshold increases every year, more and more pensioners will lose the allowance over time as their incomes rise – an economic phenomenon known as fiscal drag.

Should you adjust your income to keep the payment?

Whether you take steps to plan for this impending change will depend on certain factors. Chief among these is whether you’re able to adjust your income. Income from things like lifetime annuities, defined benefit (DB) pensions in payment and the state pension are rigid, so if the total of these sources takes you above £35,000, there’s little you can do to keep the winter fuel payment.

If your income runs close to £35,000 and you have the flexibility to tailor your retirement income, such as from self-invested personal pension (SIPP) withdrawals or your wider investment portfolio, some planning here can be a prudent thing to do. Due to the cliff-edge nature of the new system, tweaking your income can help you escape a painful and unwanted effective tax rate.

As the table above shows, tipping your taxable income over £35,000 by just £100 could reduce your household income by up to £320 (£20 tax plus £300 lost winter fuel payment), leaving you financially worse off.

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For those close to the cliff edge and who need to draw some extra cash, it might be worth being a bit strategic with your income, where possible. This can include making withdrawals from individual savings accounts (ISA) instead of your SIPP as these won’t be added to your tax bill, or using any remaining pension tax-free cash.

If you have investments outside tax wrappers, your £3,000 annual capital gains tax (CGT) exemption and £500 dividend allowance can also come in handy. This is the profit you can realise every year from selling assets without paying tax. Premium bond prizes are also tax free, so do not form part of your “taxable income”.

The message here for those potentially impacted, is that a simple tweak to which assets within your savings and investment portfolio you use to top-up your income could enable you to keep some useful cash.

While this can be a sensible approach for certain individuals and households, something to avoid is keeping your income below £35,000 just to retain the winter fuel payment. Should you need more than this amount to fund your required retirement lifestyle, then don’t let the new regime dictate your decision-making. I would say it’s something not to overlook for those genuinely impacted and potentially disadvantaged, but not something to place front and centre when planning your finances in later life.