Hundreds of thousands of women pensioners who have taken advantage of the marriage allowance could face unexpected tax bills due to the soaring state pension and frozen personal allowance.
Former pensions minister Steve Webb says it could spell “mayhem” and “chaos” for wives who handed over part of their tax-free allowance to their spouse and now find they are taxpayers for the first time.
“This is yet another unwelcome by-product of the year-on-year freeze in the value of the personal allowance,” says Webb, a partner at the consultancy LCP.
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He tells MoneyWeek that the frozen tax allowances have “hit people much harder than expected, and now people on very modest incomes are being dragged into the tax net”. Despite calls to increase the thresholds, the chancellor refused to alter them in his Autumn Statement.
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We explain how the marriage allowance works, the double whammy that could cause tax chaos for hundreds of thousands of mainly female pensioners, and what affected couples can do.
What is the marriage allowance?
The marriage allowance applies to married couples and those in a civil partnership where one partner does not pay income tax - or their income is below the £12,570 personal allowance - and the other partner pays basic-rate income tax. In most cases, the husband is the taxpayer and the wife is the non-taxpayer.
The marriage allowance works by transferring up to £1,260 of the lower-earning partner’s personal allowance to their spouse or civil partner who earns more. This alters the tax liability for each person - but the couple pays less tax overall. The maximum tax saving per couple is £252 a year.
More than 2.1 million couples benefit from the marriage allowance, and just over a third are pensioner couples.
Webb believes hundreds of thousands of pensioners - mainly women - correctly applied for the marriage allowance tax break as they did not pay income tax. But they are now discovering they are taxpayers - and therefore not eligible for the tax break - due to the rise in the state pension and the personal allowance remaining at £12,570 for the past two years.
Many more are likely to be in this position in future years as the state pension jumps again next April, and the personal allowance freeze continues.
What is causing the marriage allowance mayhem?
Many pensioner couples that have applied for the marriage allowance face being caught out by a double whammy of tax and pension issues.
First, the frozen personal allowance is dragging more and more people into the income tax net, a process known as fiscal drag. The personal allowance is set to remain at £12,570 until April 2028.
This is bad news for workers, but even worse for those who benefit from the marriage allowance as their personal allowance is smaller, due to a portion of it being transferred to their spouse. For these people, their personal allowance is £11,310.
Second, the state pension will rise by 8.5% next April, meaning the full new state pension will jump from £10,600 a year to £11,502.
This is more than the £11,310 shrunken personal allowance.
So, those benefitting from the marriage allowance may find their state pension takes up the whole of their personal allowance and they are hit with a surprise tax bill. Anyone with additional income, such as from a private pension, annuity or buy-to-let, will face even higher tax demands.
About 650,000 pensioners will have to start paying income tax as a result of next year’s increase to the state pension - many of whom may be benefiting from the marriage allowance.
Webb comments: “Hundreds of thousands of women have signed over part of their tax-free allowance in order to reduce their husband’s tax bill [via the marriage allowance]. But as the state pension rises many of these women may now find they end up with an unexpected tax bill.
“We could see marriage allowance ‘mayhem’ as couples have to decide whether to carry on with this arrangement or cancel it.”
MoneyWeek asked HMRC about this marriage allowance issue, and was told to contact the Treasury instead.
The Treasury provided this comment: “Pensioners whose sole income is the new state pension and who have not deferred or receive protected payments do not pay any income tax, and this year we provided the biggest ever cash increase to pension payments, a 10.1% rise.
“Our tax burden remains lower than any major European economy – and by raising personal thresholds over the past decade we have taken three million people out of paying tax altogether."
What can pensioner couples do about this?
The person who has become a taxpayer will normally have their tax collected via a tax demand in the post after the end of the financial year.
Webb explains that affected couples then need to decide whether to carry on with the marriage allowance, with the partner who was previously a non-taxpayer now paying a tax bill each year.
Or they can cancel the marriage allowance, but this will increase the higher earner’s tax bill and potentially leave the couple worse off overall.
You must cancel the allowance if you get divorced or your civil partnership ends. This can be done online.
If your income changes and you’re not sure what to do, call HMRC on 0300 200 3300 (Monday to Friday 8am to 6pm) for guidance.
Calls to unfreeze the personal allowance
Calls are growing for the personal allowance to be taken out of the deep freeze - which would alleviate this particular marriage allowance problem, and bring joy to millions of workers, boosting their tax-home pay.
Webb notes that the policy of freezing the tax thresholds has been far more draconian than planned due to the surge in inflation.
He tells MoneyWeek: “Freezing tax allowances has been a huge money-spinner for the chancellor, and it is easy to see the attraction – billions of pounds of extra tax revenue are generated without ever having to announce a higher rate of tax.”
According to Webb, as well as the extra tax people have to pay, it also “causes a lot of administrative hassle and inconvenience for the people concerned and, to be honest, for HMRC as well." He is urging the chancellor to review the situation and announce an increase in next year's Budget.
Nimesh Shah, chief executive of the accountants Blick Rothenberg, notes that there are significant calls from government backbenchers for tax cuts to be announced so they take effect in time for next year’s General Election.
He says a generous increase in the personal allowance to £15,000 would help those on the lowest incomes and those pensioners potentially brought into the tax net. However, he cautions that there would be a sting in the tail for higher earners.
“Due to the abatement of the personal allowance for those with income over £100,000, some of the ‘giveaway’ would be recouped as more taxpayers would be pulled into the 60% tax rate between £100,000 and £130,000 (currently £100,000 to £125,140).”
