WITH just days to go until Chancellor Rachel Reeves’ first budget – we look at how some state pensioners could end up paying tax and how to avoid it.
One move the Labour government have been rumoured to be considering is an extension on freezing income tax thresholds.
Retirees could end up paying tax on their state pension[/caption]
These determine how much you can earn before paying basic, higher, or additional rate tax.
The Personal Allowance – the amount you can earn before you start paying income tax – has been set at £12,570 since 2021.
It is meant to remain frozen until 2028, but the rumour is that Rachel Reeves could continue the freeze to 2030 or beyond.
Freezing tax thresholds – the point where you start paying higher rates of income tax are also frozen – is a stealth move that’s making us all pay more.
As wages rise, more of us are being dragged into higher tax bands.
A study by the London School of Economics found that by the 2027/8 tax year, the average person will hand over 13.6% of their income to the taxman, up from 11.6% in 2021/2 – all thanks to static tax thresholds.
It’s not just workers feeling the pinch. Pensioners are getting hit too, with the unmoving thresholds affecting their finances as well.
Your pension – including the state pension – isn’t exempt from income tax.
However, up until now, most pensioners have avoided paying it, thanks to the Personal Allowance shielding their income.
“Frozen tax thresholds are stealthily pushing up our tax bills and we face the very real prospect that in the coming years someone solely reliant on the state pension will have to pay tax on it,” says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.
Thanks to the Triple Lock the state pension rises every year – it’s set to go up by 4.1% next April.
The Triple Lock guarantees that your state pension increases annually by whichever is higher: average wage growth, inflation or 2.5%.
It is a generous safeguard, boosting the full state pension from £9,339.20 in 2021 to £12,016.75 from April 2025.
But this could lead to a collision with the Personal Allowance, which is frozen at £12,570, just a few hundred pounds above the state pension.
How does the state pension work?
AT the moment the current state pension is paid to both men and women from age 66 – but it’s due to rise to 67 by 2028 and 68 by 2046.
The state pension is a recurring payment from the government most Brits start getting when they reach State Pension age.
But not everyone gets the same amount, and you are awarded depending on your National Insurance record.
For most pensioners, it forms only part of their retirement income, as they could have other pots from a workplace pension, earning and savings.
The new state pension is based on people’s National Insurance records.
Workers must have 35 qualifying years of National Insurance to get the maximum amount of the new state pension.
You earn National Insurance qualifying years through work, or by getting credits, for instance when you are looking after children and claiming child benefit.
If you have gaps, you can top up your record by paying in voluntary National Insurance contributions.
To get the old, full basic state pension, you will need 30 years of contributions or credits.
You will need at least 10 years on your NI record to get any state pension.
If the Triple Lock triggers a rise of 4.6% or more in April 2026 anyone receiving the full state pension will be liable to pay income tax on it.
With pension increases of 10.1% in 2023 and 6.7% in 2024, it’s highly likely the state pension could exceed the Personal Allowance soon.
“Rachel Reeves’ decision to brutally scale back the Winter Fuel Payment will see millions of pensioners taking a hit of up to £300 later this year,” says Tom Selby, director of public policy at AJ Bell.
“There could, however, be a silver lining coming in April 2025 in the form of a bumper state pension boost linked to average earnings growth figures.
Although even this could come with a catch.
“While the personal allowance remains frozen, more and more people are going to be dragged over the threshold, with millions of retirees just receiving state income at risk of being dragged into paying income tax.”
The idea of paying tax on a state benefit might sound crazy, but that’s exactly where we’re heading.
One option could be for the government to introduce a pensioner tax allowance – something the Conservatives dubbed the ‘Triple Lock Plus’ before the election.
This would keep the state pension below the tax-free threshold.
But Labour wasn’t having it at the time, calling the plan not ‘credible’.
Even if the government finds a way to shield the state pension from income tax, frozen thresholds will still drag millions of pensioners into paying tax during retirement.
Just a small private pension could be enough to push them over the Personal Allowance.
“The triple lock may increase state pensions, but with tax thresholds frozen, many will find themselves paying taxes on what should be a lifeline during retirement,” says Jon Greer, head of retirement policy at Quilter.
“For those with a combination of state and private pensions, the hit will be felt even sooner, eroding their incomes at a time when financial security is crucial.
“Compounding this pressure, Reeves’ decision to axe the Winter Fuel Payment adds salt to the wound.
“Together, these policies threaten to squeeze pensioners from all sides.”
If you are worried about paying income tax on your pension, there are steps you can take to reduce what you owe.
Right now, most people who rely solely on the state pension for their retirement don’t pay any tax.
But if you’ve got the state pension and other sources of income in retirement you may face a bill from HMRC.
“Pensioners looking to manage their tax bills should plan their incomes carefully,” says Morrissey.
One trick is to make the most of your tax-free lump sum.
Most of us can take 25% of our private or workplace pensions tax-free, but you don’t have to grab it all at once.
You can take a small amount each year to top up your income, letting you take less from your taxable pension.
For example, if you need £15,000 a year to live on, and you’ve got the full state pension plus £60,000 in your private pension, here’s a trick.
After your state pension, you still need £3,500 a year.
Since you can take £15,000 of your pension tax-free, you could take £1,000 as income from your pension and £2,500 from your tax-free lump sum.
This way, you’ve got the cash you need, without handing any of it to the taxman.
Another option is to boost your pension income without a tax bill by dipping into your savings.
“Any money taken from an ISA is tax free so this could prove handy in keeping those bills down,” says Morrissey.
You can use your savings just like the tax-free lump sum, reducing how much you need from your private pension and keeping your taxable income lower.
But in the end, the Government needs to face up to the fact that we’re heading toward a crazy situation where pensioners are taxed on their state pension – and they need to act before it’s too late.
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