Thousands of pensioners will have to start paying income tax due to the massive rise in the state pension next April.
The state pension will jump by 8.5%, as confirmed by the chancellor in his Autumn Statement. This means the full new state pension - paid to those who reached state pension age after April 2016 - will increase by more than £900 a year to £11,502.
The basic state pension will rise to £8,814.
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The bumper increase next year is thanks to the triple lock mechanism, which guarantees an annual increase in the state pension of 2.5%, wage growth or inflation - whichever is higher.
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While pensioners and those approaching retirement will be cheering the 8.5% rise - the second-biggest increase to the state pension - many will be dragged into the income tax net and will have to start paying tax on their income.
“Alongside a continued freeze of the tax-free personal allowance, the big rise in the state pension is likely to drag well over half a million more pensioners into the income tax net. Once again, ‘stealth’ taxation proves a convenient revenue raiser for the chancellor,” comments Steve Webb, partner at the consultancy LCP, and a former pensions minister.
The pensions tax trap
The personal tax threshold will be frozen again at £12,570 next year. This means pensioners receiving the full annual state pension of £11,502 will only need a small amount of extra income - such as from a personal pension, workplace pension, or part-time earnings - to be dragged into the tax net.
To be precise, the state pension will take up 92% of the personal allowance, with pensioners just needing an additional £1,068 of income to cross the tax threshold.
Dean Butler, managing director for retail direct at Standard Life, notes: “The personal allowance has been frozen since 2021/2022 and currently remains fixed for quite a few years to come. This means the full state pension payment has grown from 70% of the allowance in 2019/20 to 92% next year.”
How many people will be affected?
Between 2022-23 and 2023-24, HMRC figures suggest that the number of those aged 65 and over who pay income tax rose from 7.73m to 8.5m, due to the 10.1% increase in the state pension in April 2023.
According to LCP, a further rise of 8.5% in the state pension will likely result in an extra 650,000 pensioners paying tax, taking the total to 9.15m in the 2024-25 tax year. In contrast, only about 4.5m over-65s paid income tax in 2010.
Jason Hollands, managing director at the wealth management firm Evelyn Partners, remarks: “Anyone with even a very modest private income will be tipped into paying basic-rate tax at 20% next year.”
In fact, there will only need to be a few more small increases to the state pension in future for it to breach the personal tax allowance - throwing all retirees that receive the full new state pension into the tax net.
Hollands explains: “In the next three years it will require triple-lock increases of just a sliver greater than 3% to take the annual state pension above the annual personal tax allowance.”
He adds that this would present a conundrum for the government: they could either “create an administrative and political headache by taxing the state pension, possibly at source – which would be massively unpopular among the more than 13 million people then expected to be of state pension age - or make the headache go away by raising the personal tax allowance for everyone”.
Should I still save into a pension?
The idea of paying tax on your retirement income due to a large jump in the state pension may make you think twice about building up a big private pension.
While saving into a pension attracts tax relief, when you come to take money out it is liable for tax.
Hollands notes that pension saving can still be very tax-advantageous, particularly if a saver is a higher or additional-rate taxpayer in their working life but then a basic-rate payer when they draw on their pension.
However, he adds that a soaring state pension “does serve to remind today’s savers of the value of ISAs, which can provide a valuable supplementary income to pensions during retirement that is not taxed at access. Although contributions to ISAs for most people will be made from taxed income".
