Monday, December 23, 2024

How to beat the state pension triple lock tax trap

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Half a million pensioners are to be dragged into paying income tax with the latest rise – fizkes/iStockphoto

From April 7 2025, more than 12 million retirees are on course to receive a 4pc boost to their state pension thanks to the “triple lock” with wages expected to rise faster than prices.

It means around an extra £460 more for those on the full new, post-2016 state pension.

Yet it’s not all good news for those who have retired.

A significant amount of what many will gain could instantly be clawed back in tax, thanks to the Government’s stealth tax rises, sometimes called fiscal drag. The rise means 300,000 pensioners will be dragged into income tax for the first time.

Others may also lose the £252-a-year marriage allowance which cannot be claimed once one spouse becomes a higher-rate payer.

It comes as Chancellor Rachel Reeves scrapped the winter fuel payment for those not claiming pension credit or other means-tested benefits, taking up to £300 out of 10 million pensioners’ pockets.

As the state pension increases, Telegraph Money takes you through what you need to know and how to reduce your tax bill.

How much more will I get – and why?

The triple lock, introduced by the coalition government, took effect in the 2011-12 tax year. It guaranteed that the state pension would increase annually by the highest of inflation, average earnings growth or 2.5pc.

From April 7 the basic state pension will rise by around £7 a week, or £353 a year, and the “new” state pension, paid to anyone retired since April 2016, will jump by £8.85 a week, or around £460 a year. Those on the full new state pension look set to receive almost £12,000 for the 2025-26 tax year.

Are state pensions taxable?

The state pension is paid “gross” with no tax taken off. The full amount is rising but still falls below the personal (tax-free) allowance of £12,570 a year. However, state pension income does count towards the allowance, and the threshold is frozen until April 2028.

If you’re on the full, new state pension, just £607.40 in extra income from other sources will now tip you into paying tax. Some people will also find themselves breaking into a higher tax threshold.

It also means that more than 300,000 pensioners will be dragged into income tax when they weren’t before. This takes the total number of tax-paying pensioners to around nine million, almost double the number in 2010.

Here are some ways to avoid paying tax on your pension.

Be aware of tax brackets

Mike Ambery, of retirement provider Standard Life, part of Phoenix Group, said: “This inflation-beating uplift will be some comfort for pensioners grappling with high energy prices and, for those not claiming pension credit or other benefits, staring into their first winter without the £300 fuel allowance.

However, a new state pension of £11,962.60 will also be 95pc of the personal allowance, currently frozen at £12,570 until 2028 – by contrast, in 2021/22 the new state pension was equivalent to 74pc of the allowance. This means pensioners will need just £607.40 of other income before paying income tax.

Anything you earn below £12,570 is usually tax free. If you earn between £12,570 and £50,270, you will pay a rate of 20pc. The higher rate is levied at 40pc on anything between £50,271 and £125,140, then you pay 45pc on anything over that.

You also need to watch how near you are to the next tax bracket. If you currently earn close to £50,270, the increase could push you into the next rate, meaning you start losing 40pc to tax.

In addition, for every £2 you earn over £100,000, your personal allowance reduces by £1, which will also inflate your tax bill.

For example, if you earned £99,999, the £640 would take you to £100,639 and remove £319.50 of your personal allowance. Not only would you pay 40pc tax on earnings over £100,000, you also pay that on the £319.50 of lost allowance. This leaves you with £256.60 of the original £640 boost, meaning you’ve paid 60pc in tax.

If this applies to you, it could be worth trying to lower your earnings to get into a lower tax bracket.

Take your time on private pension withdrawals

The increase in the state pension might mean you don’t need to start drawing all, or any, of your private pensions yet. This can cut your tax bill and give your pension longer to grow – unspent money left in a pension is also free of inheritance tax, unlike cash in a bank account or Isa.

Annuities linked to inflation and “defined benefit” pensions, often known as final salary pensions, will increase too. You should factor this into any decisions.

There’s also the option of spreading out your tax-free lump sum. Dean Butler, also of Standard Life, said: “In most cases, pensions offer the ability to withdraw 25pc tax free. You don’t have to take all of this money in one go, and by spreading the sum over multiple years, you can help keep your taxable income below the different tax thresholds. If you’re just accessing the tax-free element of your pension, the remainder also has the potential to grow over time if left invested.”

Take less from your drawdown

Once your pension is in a “drawdown” account you can withdraw from your fund when you need to. This is subject to income tax, but since you’re in charge of how much you take out and when, you control how much tax you pay.

If you’re currently living comfortably on a set amount, you could reduce your drawdowns by the same amount that the state pension increases. Not only do you avoid tax on money you don’t need yet, you can also leave that money in your account, meaning it’ll keep being invested and could be worth more when you do take it.

Defer your state pension

You could look at deferring your state pension, particularly if you’re still working. For each nine weeks you defer, you’ll get an extra 1pc when you do claim it. If for example you pay income tax at 45pc, claiming your state pension now will mean it is taxed at this rate.

If you wait until you’ve stopped working, your income could drop significantly and you’ll pay less tax. In the meantime, your state pension payments are building up for when you do claim.

You can still do this even if you’ve started claiming, but only once.

When exactly do you get paid?

When you apply for the state pension, you choose when you’d like it to start. The first payment, which may not be the full amount, will be made no later than five weeks after that. Full payments are then made every four weeks from that date.

The day of the week you are paid depends on your National Insurance number, see table below.

Salary sacrifice

If you’re still working, salary sacrifice is a way of reducing your income for non-cash benefits. You could do this with a range of options including pension contributions, one-off purchases, and travel. Crucially, by earning less money, you pay less tax.

Mr Butler said the same applies to bonuses. He added: “If you get a work bonus, you might have the option to put some or all of it into your pension. Doing this could save on tax and National Insurance deductions, meaning you get to keep more of your bonus in the long run.”

However, if you’ve already taken income from any private pension, there are significant tax implications.

Remember pension savings can be passed to your loved ones tax-free

Pensions, unlike Isas, generally don’t form part of your estate when you die, so inheritance tax isn’t normally payable. If you die before your 75th birthday, and it’s paid to your loved ones within two years, they also won’t need to pay income tax on it.

This means if you have a pension that you don’t yet need, you could avoid ever paying tax on it by leaving it as an inheritance.

If you die after the age 75, or it’s accessed after more than two years, inheritance tax still will not be due, but income tax will be at the marginal rate of whoever inherits it.

The Marriage Allowance

If you earn less than £12,570 and have a spouse or civil partner who earns more, you can pass £1,260 of your tax-free allowance to them. If you earn less than £11,310, that could save your household £252 in tax. This is known as the marriage allowance.

Due to the latest increase, anyone getting the full state pension will now exceed that amount, meaning you lose £192 of the tax-free allowance you could pass on – costing you an extra £38 a year.

Likewise, if either spouse’s income goes above £50,270 they will lose the allowance.

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