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Far more pensioners are paying income tax now than was previously thought, according to official figures. The actual number of pensioners paying tax has also reached record levels.
We look at why income tax bills are becoming a concern for so many pensioners. We also ask financial experts for tips on the best ways for individuals to keep tax liabilities to a minimum helping them hang on to more of their money.
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Figures from the Department for Work and Pensions suggest that around 12.2 million people in the UK receive the state pension. Nearly three-quarters of these individuals are now taxpayers, and this number is forecast to grow by another million by the 2030-2031 tax year.
HMRC, the UK’s tax authority, recently published figures which revealed far more pensioners are now paying income tax than had previously been estimated. The findings also showed that the number of pensioners paying income tax has reached record levels.
There’s a simple reason for this. Everyone receives the annual personal allowance, a threshold below which no income tax is due. The allowance currently stands at £12,570 and has remained the same since 2021. It is not due to be reviewed for another five years.
During the five-year period where the threshold has been frozen, the number of individuals aged 65+ and liable for tax has risen by more than three million.
The increase in numbers is mainly accounted for by year-on-year rises in the state pension as a result of the ‘triple lock’.
The lock is essentially an uprating calculation that was introduced by the government in 2010. It currently dictates that, at the start of each new tax year in April, the state pension will rise by either wage growth, inflation, or a minimum value of 2.5%. Introduced in 2016, the standard new state pension is currently worth £241.30 a week, or £12,548 a year, already making it within touching distance of the personal allowance.
The state pension for the 2027/28 tax year is yet to be finalised. But even if the minimum 2.5% uplift was to be applied, this would hike the state pension next Spring to £12,884, thus breaching the existing threshold.
Consequently, even those solely in receipt of the full, new state pension could become liable for basic rate tax.
Alanah Mitchell, financial planner at Rathbones, says: “It’s clear that the triple lock will keep increasing the state pension. As a result, the gap between pension income and the personal allowance is likely to close by April 2027, meaning over-65s will soon see their state pension and any additional income move into the basic rate tax band.”
Responding to this scenario, John Healey, the Chancellor of the Exchequer in the new, Andy Burnham-led Labour government, has confirmed that pensioners whose only income is the state pension will not have to pay income tax next year.
But critics have slammed this decision. They argue that not only does this create a two-tier system, but that it is also unfair on pensioners with small, supplementary incomes - from private pensions, for example - as this will lead them to being taxed.
Steve Webb, a former pensions minister who is now a partner at pensions consultancy LCP, describes the policy as a “very flawed sticking plaster”.
Paying needless amounts in tax is a financial planning no-no. Especially if smarter options exist to squirrel away your money, or better organise your finances, tax-free.
This applies whether your retirement finances mean you’re in danger of just breaching the tax-paying tipping point, or even if you’re in receipt of a pension that comfortably exceeds the annual allowance.
Scott Gallacher, chartered financial planner and director at independent financial advisers Rowley Turton, says: “Broadly speaking, couples should think about how they hold their savings and investments. I often see one spouse owning most of the income-producing assets. At the same time, the other has spare tax allowances going unused.
“Where appropriate, holding assets in the most tax-efficient way across both partners can make better use of each person's allowances and reduce the household's overall tax bill.
Gallacher also advises individuals to check their tax codes carefully. A tax code is a mix of letters and numbers issued by HMRC and used by employers and pension providers to work out how much income tax to deduct from your pay.
Gallacher explains that: “Retirees often receive income from several sources, including the state pension, occupational pensions, personal pensions and savings.
“If HMRC's estimate is wrong, too much or too little tax may be collected. Anyone taking an occasional pension withdrawal should also check whether emergency tax has been deducted.”
If you have a lot of savings, and depending on your income needs, Adam Vanstone, chartered financial planner at Chester Rose Financial Planning, suggests individuals could stagger the maturities of fixed-term deposits so the interest you receive is spread over different tax years.
“That way, you can make the best use of your £5,000 starting rate for savings [applicable for those whose income from work or pensions falls under the personal allowance threshold] and your £1,000 personal savings allowance each year.”
Katy Allen, chartered financial planner at One Four Nine Wealth, says couples also overlook the Marriage Allowance. “This is often forgotten, but it allows a non-taxpaying spouse to transfer up to £1,260 of their unused personal allowance to their spouse/civil partner each year.
“The proviso is that the recipient is a basic rate taxpayer as this not available to higher or additional rate taxpayers. The recipient can then benefit from an additional tax saving on their income of up to £252 per annum.
“While not a ‘life changing’ annual tax saving, if you haven’t claimed in previous tax years, you might be entitled to a little bit more. You can backdate your claim by up to four tax years, which may provide an additional £1,008 tax saving at outset.”
Scott Gallacher says one of the common mistakes he sees “is people paying tax on savings and investments when they haven't fully used their ISA allowances”.
“ISAs remain one of the easiest ways to shelter money from income tax and capital gains tax. Yet, many people still hold substantial sums outside them. Each person can currently put up to £20,000 a year into ISAs, meaning a couple can shelter up to £40,000 a year.
“At an interest rate of 4%, that could protect £1,600 of annual interest from tax. Over five years, by using both of their ISA allowances, a couple could move as much as £200,000 into ISAs, significantly reducing their future income tax liabilities.”
The experts say the timing of pension withdrawals can play a significant role when it comes to tax as well.
Scott Gallacher explains: “Taking a large taxable withdrawal in one tax year can push part of that income into a higher tax band, whereas spreading withdrawals across different tax years may produce a better outcome.
“This is particularly relevant for people who retire before their state pension begins, as they may have several years in which some or all of their Personal Allowance would otherwise go unused.
“Carefully planned pension withdrawals during that window can be more tax-efficient than waiting and taking the same income once the state pension is already using much of the allowance. It is a good example of why retirement income should be planned over several years rather than one decision at a time.”
Katy Allen says: With most ‘modern’ private pension arrangements, up to 25% of the pension fund can be accessed as a tax-free lump sum, with many investors electing to draw this as a one-off lump sum at outset.
“But your tax-free cash entitlement can also be ‘phased’ out of your pension, drawing out only what is required based on your circumstances. For example, a monthly tax-free cash withdrawal could be used to top up other sources of taxable income, without any additional tax liability.
“This route does, however, come with risks – namely, that there is no guarantee funds withdrawn in this manner will last throughout retirement.’
Adam Vanstone says savers should also consider Premium Bonds. “You can invest up to £50,000 and your money is completely safe because it is backed by the government. Returns come from a monthly prize draw, with an average prize rate currently at 3.8% a year.
“Just remember that winning is not guaranteed. You may win nothing, or you might get lucky and win more. But if you do win, every prize is tax-free and there’s always the off chance you could scoop one of the bigger prizes.
“When you compare these returns to ordinary savings accounts, outside an ISA, which are taxed, Premium Bonds can work out at an average of 4.75% a year for basic-rate taxpayers and 6.3% for higher-rate taxpayers. That, of course, is dependent on you being a winner.”
Rathbone’s Alanah Mitchell also gives the thumbs up to Premium Bonds. She adds: “While the returns aren’t guaranteed, the winnings are tax-free and your funds remain accessible with withdrawals typically processed in a few days.”
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