Pensioners can ease the tax pain as frozen thresholds raise burden on retirees

The state pension increases by 8.5 per cent on Monday 8 April, meaning those receiving the new full rate will see their annual payout rise to £221.20 a week, or £11,502 a year.[1] Those receiving the basic state pension will see their payout rise to £169.50 a week, or £8,814 a year. The latest bumper state pension rise takes the annual payout a step closer to the personal tax allowance of £12,570.

Research this week suggested 1.6 million more pensioners will be dragged into paying income tax within four years than would have been the case if the personal allowance had risen with inflation, with around 1.2 million of that increase occurring in the coming 2024/25 tax year.[2] That would mean the number of pensioner income taxpayers is set to nearly double from about 4.9 million in 2010.

Henrietta Grimston, Director of Financial Planning at leading UK wealth manager Evelyn Partners, says: 'Not many pensioners will be complaining about a boost to their weekly state pension payments. But as this latest increase - like those of the last couple of years - comes against a background of frozen tax thresholds, it does mean increasing numbers will be pushed into paying income tax, or into a higher tax band.

'Most of those receiving the new full rate SP will only be able to draw £1,068 in income that is not covered by other allowances before they start paying income tax at the basic rate of 20 per cent in the new tax year. And those with more substantial sources of private income who are close to the higher rate threshold of £50,270 could be pushed into paying tax at 40 per cent on some of their income.'

HMRC figures show that the number of those aged 65 and over who pay income tax rose 10 per cent from 7.73 million in 2022-23 to 8.5 million in 2023-24 due to the 10.1 per cent increase in the state pension in April 2023. That’s a 25 per cent increase on the 6.8 million income taxpayers of state pension age paying tax in 2020-21, after which tax thresholds were frozen

Henrietta says: 'Frozen income tax thresholds and the concept of “fiscal drag” are becoming facts of modern-day financial life – and for those whose incomes are advancing along with their careers, it’s largely a pill to be swallowed as there are few ways to relieve the burden. But those in retirement might have more flexibility to plan their income for tax efficiency, not least by using their allowances and exemptions carefully.

'Even the majority who envisage paying only basic rate tax on their retirement income can structure their assets so that their savings will be less depleted than they need to be by contributions to HM Treasury.’

Moreover, Ms Grimston adds, ‘This is an issue that will only escalate over the coming years as the state pension remains on a collision course with the personal tax allowance.’

The 8.5 per cent boost to the state pension has been determined by the average earnings element of the triple lock, while the 10.5 per cent rise that kicked in last April was dictated by the consumer prices inflation element. Chancellor Jeremy Hunt last month confirmed that the Conservatives’ election manifesto would include a commitment to the triple lock and recent reports have predicted that Labour’s will too.

Henrietta says: 'Unless something gives, those of SP age will automatically be liable to income tax on the SP itself, even if they have no other source of income.'

What happens when the state pension is taxable?

The state pension does not get taxed before it arrives, and is often ‘coded out’ against other PAYE sources of income. This means that more tax is taken off other sources of income to collect any due on the state pension.

If you do not have enough other PAYE income for this process, HMRC is likely to issue a ‘simple assessment’ after the tax year ends, with the tax being due by the following 31 January. But some state pensioners may need to fill in a full self-assessment tax return.

Ms Grimston says: ‘With or without the help of an accountant, it’s best to check that your PAYE code is correct and to check any simple assessment.'

How can retirees ease the tax burden?

There are a number of mitigation tactics available to many of the 8.5 million pensioners who are already paying income tax.

Henrietta says: 'By keeping an eye on their exemptions and allowances, savers can make sure they are making the most of their retirement savings by not handing over excess sums to the Treasury. They can make sure they are drawing from their personal pensions tax-efficiently, and those with savings outside pensions, in ISAs for instance, are likely to have the most flexibility to keep overall tax bills down.

‘This is when working with a financial planner to put a proper tax-efficient plan in place can be really beneficial.’

Exemptions and allowances

Henrietta says: 'Most allowances are dwindling rapidly in real if not nominal terms, but it is still possible for a retiree to enjoy an annual income well above the personal income tax allowance without paying any tax at all.'

Personal tax allowance 
An individual in retirement with the full state pension of £11,502 per annum, can receive a private pension income (from an annuity for instance) worth £1,068 a year before they hit the personal tax allowance of £12,570.

Savings interest 
If they had substantial savings outside ISAs, a retiree could max out the starting rate of tax for savings, which is £5,000 as long as income does not exceed the personal tax allowance of £12,570.[3] The personal savings allowance of £1,000 for basic rate taxpayers means that there is potentially £6,000 in tax-free interest income available.

Investment income and capital gains 
From a non-ISA investment portfolio, one can draw an annual income from dividends up to £500 and £3,000 in capital gains - allowances that are a quarter of what they were in the 2022/23 tax year.

Trading and Rent-a-Room 
Finally, one can also earn up to £1,000 tax-free from casual trading like buying and selling on internet trading sites like eBay, thanks to the trading allowance, and £7,500 under the Rent-a-Room scheme, although these allowances will not be easy or attractive for everyone to use.
   
A couple can double most of these tax-free amounts by using both sets of allowances, and transfers of assets between married couples and those in civil partnerships does not trigger tax liabilities, allowing flexibility to achieve tax efficiency.

Tax-efficient pension access

Ms Grimston says: ‘The 25 per cent tax-free portion of a pension pot is the headline-grabber, and some savers opt to take this as a one-off lump sum. But it can also be accessed incrementally, with 25 per cent of each withdrawal taken tax free, and this strategy can be useful in minimising the overall tax burden.

‘For instance, someone determined to pay no tax at all on their pension income in 2024/25 could set their annual withdrawal at £1,424 gross. Of this, 75 per cent or £1,068 falls within the personal income tax allowance, while the remaining 25 per cent or £356 is taken from the tax-free element of the pot. In general, pension withdrawals can be gauged so that excess income tax liabilities are not incurred, especially where other non-taxable funds can be drawn on – such as from ISAs - to make up any gaps.’

She observes: 'For many pension savers the tax benefits of reliefs at the contribution stage outweigh the tax paid at access, even if withdrawals are taxed. This is most obviously and commonly the case where a saver received tax relief on their pension contributions at the higher or additional rate, but then pays tax at a lower rate when they come to draw a pension income.

‘Additionally, the tax-efficient treatment of pensions means a more favorable growth environment. Assuming positive market performance, this should result in a larger portfolio value in the future versus the same initial investment amount into say a taxable account. Therefore, even if higher rates of tax are still being paid in retirement, it is being drawn from funds that have had the benefit of growing in a more efficient way. Additionally, as up to 25 per cent of the pension can be drawn as a tax free lump sum, not all of the amount drawn will be subject to taxation.’

ISAs

These tax wrappers protect savings from income and capital gains tax, while retaining access and flexibility.

Henrietta says: 'The narrowing opportunities for tax-exempt income and capital gains highlights the growing importance of ISAs in sheltering investments from dividend and capital gains tax.

'The annual £20,000 ISA allowance is a “use it or lose it” one, and there is no guarantee a future government will not reduce that, so it is worth considering before the end of each tax year whether funds – which can be held as cash even in an investment ISA - can be committed to securing this allowance.

'ISA savings can be a valuable tax-free supplement to a pension, which may also be useful in keeping pension withdrawals in lower tax bands.' 

Premium Bonds

Premium Bond prizes are tax free, and the NS&I product currently offers an average return of 4.4 per cent.

‘That is a very handy tax-free return but an individual holder might do worse or better with their annual prize haul,’ says Ms Grimston. ‘Many savers like the fact that they have a chance of winning a big potentially life-changing prize while still receiving smaller prizes, and that bonds are essentially “easy access”. It can be an attractive option for those who are using up their personal savings allowance, and can’t or don’t want to use their ISA allowance for cash savings.’

Tax-efficient investments

More sophisticated investors can seek tax-free dividends from specialist investments such as Venture Capital Trusts and tax-deferred withdrawals from offshore investment bonds.

Investment into a VCT new share issue provides a 30 per cent income tax credit on the amount subscribed (repayable if the shares are sold within five years) and any dividends paid by the VCT are tax-free and most VCTs prioritise dividends as the main way of delivering returns to investors.

Henrietta says: 'An offshore bond is a wrapper for investments or other assets that allow them to grow free of capital gains tax. Gains can grow over time without any immediate tax charge, and you can withdraw up to 5 per cent of the total amount paid into the bond each year, up to a maximum of the initial amount invested. Because this is classed as ‘return of capital’ rather than income, there is no tax to pay.'

However, tax will be due when the capital is eventually accessed, or under certain conditions such as death of the bond holder, and that together with the fact that using offshore bonds, which come with fees, can be a complex affair means that they are something that should be approached with advice and expert help.

Ms Grimston says: 'Offshore bonds tend to be useful mainly for those who have used up all of their annual pension and ISA allowances – for instance those who are subject to tapered relief during their earning years – and are looking for a tax-efficient way to invest lump sums of capital that could also have tax benefits at access in retirement. They work best when there is an expectation of being in a lower tax bracket in the future or potentially as part of planning for a move abroad.'

NOTES

[1] This is for those who reached state pension age after April 2016, with 35 qualifying years of National Insurance contributions.

[2] House of Commons Library, commissioned by the Liberal Democrats.

[3] For every pound that income exceeds the personal income tax allowance, the starting rate of tax for savings reduces by the same, until no savings allowance is left when income hits £17,570.

Taxation disclaimer

Prevailing tax rates and reliefs depend on individual circumstances and are subject to change