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After decades of hard work and saving, you may be frustrated to find that you are paying more tax on your retirement income than before.
In April, the UK government raised the State Pension by 8.5% to maintain the triple lock guarantee. The triple lock ensures the State Pension rises every year in line with whichever is the highest out of inflation, average UK earnings, or 2.5%. In 2023/24, average earnings was the highest of the figures.
Despite the statistics from the Office for National Statistics (ONS) showing inflation levels to be falling, many people are still feeling the squeeze of the cost of living crisis on their budget. So, the State Pension increase was welcomed in many quarters.
However, Income Tax thresholds remain frozen. This has led to a “tax creep” for many retirees, as the State Pension now uses up more of the tax-free Personal Allowance.
Read on to discover what the retirement tax creep is and how you could mitigate tax in later life.
There could be an additional 1.6 million pensioners paying Income Tax by 2027/28
At the start of the 2024/25 tax year, the full State Pension rose from £203.85 to £221.20 a week – £10,600.20 to £11,502.40 a year.
Yet, the Personal Allowance and higher-rate Income Tax thresholds have been frozen since April 2021, and are set to remain so until at least 2028. As a result, the current annual full State Pension pays benefits that are only marginally below the Personal Allowance of £12,570.
This, along with the reduction in the additional-rate threshold in 2023, means retirees could end up paying more tax on their retirement income if they continue drawing the same amount as before.
If the current thresholds remain as they are until 2028, it won’t take particularly significant annual increases under the triple lock before someone only in receipt of the full State Pension will have to pay a portion of it back in tax.
The Standard reports that this could mean an additional 1.6 million pensioners could be paying Income Tax by the 2027/28 tax year compared to if the Personal Allowance was raised in line with inflation.
Careful management could help you mitigate your tax liability in retirement
Carefully managing and planning your withdrawals could help to limit the tax creep on your retirement income.
Most people can take 25% of their pension tax-free up to the Lump Sum Allowance (LSA), which is £268,275 in 2024/25. You may have a higher LSA if you previously applied for Lifetime Allowance protection.
When you reach the normal minimum pension age (55, rising to 57 in 2028), you can take this as a lump sum. Alternatively, you can draw it as multiple uncrystallised funds pension lump sums (UFPLS), whereby 25% of each withdrawal you make is tax-free.
Deciding when and how to withdraw your tax-free lump sum can be critical for ensuring tax efficiency, particularly if you are looking to fund big expenses such as trips abroad or trusts for your children or grandchildren.
You could also consider drawing from any ISA savings you may have to complement your pension, as withdrawals you make directly from your ISAs are not liable for Income Tax.
With careful planning, you can help to ensure your tax-free pension and ISA withdrawals along with your State Pension provide you with adequate retirement income while limiting your tax liability.
It is a good idea to speak with a financial planner to plan your withdrawals in line with your retirement goals, ensuring your income is as tax-efficient as possible.
You can defer your State Pension, though you should consider if this will be beneficial
The State Pension Age is currently 66, rising to 67 by 2028.
Yet, when you reach the State Pension Age, you don’t automatically receive the payments, you have to claim them. So, if you don’t need the extra income, you can choose to defer your State Pension, which could be beneficial if receiving it would push you into a higher tax bracket.
Of course, deferring your State Pension could mean you have bigger tax bills to pay when you finally come to claim it, as you would be claiming a larger amount. That said, it could be beneficial to wait until Income Tax thresholds rise or until you have depleted other forms of income.
For every nine weeks you defer your State Pension, you receive an additional 1% when you come to claim it. This works out to an increase of around 5.8% for every year you defer.
So, as the new full State Pension is £11,502 a year, deferring it for a year will increase it to £12,169.10 – a rise of £667.
This means it will take around 17 years to recoup what you deferred, or perhaps around 15 years if you account for compound growth.
Of course, there is then the question of life expectancy and whether you are likely to recoup the full value of your deferral before you die.
Data from the ONS shows that the average life expectancy of male and female 67-year-olds is 85 and 88 respectively, meaning the average retiree could recoup any State Pension they defer in full.
Even if you did not recoup the full value of your deferral, doing so could still help you manage your tax liability more effectively.
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A financial planner can help you navigate the complexities of pension withdrawals, ensuring you don't pay more tax than necessary on your retirement income.
Developing a tailored plan that maximises your retirement benefits and minimises your liabilities can provide peace of mind and financial security for your future.
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Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning.