Millions of pensioners could have income tax automatically deducted from their state pension under plans reportedly being considered by Labour.
The full new state pension is set to rise above the tax-free allowance of £12,570 next year for the first time, meaning those whose sole income comes from the state payment may face a tax bill.
Pensioners with private income already over the £12,570 threshold already pay tax.
Chancellor Rachel Reeves had said earlier this year that those who live only on the state pension would be exempt from paying tax when it goes above the threshold.
In an interview with Martin Lewis, she had said those living solely the state pension would not have to fill in a tax return, then added: “In this Parliament, they won’t have to pay the tax.”
Yet under reported Government plans, the basic 20 per cent rate of tax could be applied to payments when it increases, and the money might be deducted prior to money being sent to retirees, according to City AM.
For many pensioners – those who have extra income on top of their state pension – the impact would simply be receiving less money in each payment up front, rather than facing a tax bill for the payments later.
However, for those who expected to be exempt, it could mean facing tax they did not expect to pay.
Tom Selby, director of public policy at AJ Bell, said the issue showed the complications that the taxman was facing. “Regardless of what the Government chooses to do, it is likely to be an administrative headache for HMRC,” he added.
The issue has emerged because of the triple lock, which ensures the state pension continues to rise by the highest out of inflation, earnings growth or 2.5 per cent. At the same time, the personal allowance – the amount you can take in income tax-free – remains frozen at £12,570.
As a result, pensioners who previously paid no income tax are increasingly being pulled into the system through fiscal drag.
The full new state pension is currently £12,547 per year, so even at 2.5 per cent increase next year would take it above the £12,570 threshold.
Who could be affected?
The latest figures show 13.2 million people claim the state pension, with 8.7 million people over state pension age paying income tax.
Experts at financial consultancy LCP estimate that around 820,000 retirees will owe income tax on their state pension alone in 2027-28.
The number of people who would be affected will depend on how the proposals work – if they are implemented.
Andrew King, pensions specialist at wealth management firm Evelyn Partners, said pensioners who rely almost entirely on the state pension could be the most affected.
These people have little or no other sources of income, and are the most likely to notice the changes, with automatic deductions meaning they would receive less money each week than if HMRC did not deduct the tax – as Reeves had suggested would be the case.
Someone on the full new state pension would receive £12,860 from next year if the state pension went up by 2.5 per cent. This would attract an income tax bill of £58, leaving a person with just under £5 less a month than if the money were not taxed.
Millions of pensioners receive less than the full new state pension, so would under the £12,570 tax threshold even after a rise. It is unclear if these people would automatically have tax deducted from their pensions but then get the money back later.
Some other pensioners already receive a state pension bigger than the £12,570 personal allowance. Some older retirees can have their state pension supplemented with extra income under the State Earnings Related Pension Scheme (Serps).
King said he knew someone who received a state pension of more than £20,000 as a result of Serps and paid the tax they owed – over £1,000 – via a tax return later in the year.
If the new automatic deduction were implemented, he said they would receive less money up front, instead of receiving a higher amount and paying back the tax later. Either way, the figure they would actually pay in tax, in the end, would be the same.
Experts warn against ‘tax now, refund later’
It is unclear at the moment how the Government would take the tax charge automatically.
Experts have warned against taking a flat 20 per cent charge from the entire state pension, and then repaying the correct amount.
Instead, they say a system that deducts the correct amount at source would simplify matters over time.
Alasdair Mayes, partner at LCP said: “Applying a 20 per cent deduction to the whole state pension would be using a sledgehammer to crack a nut. It would affect 13m people and deduct far more tax than was due.”
‘Increasing pensioner poverty at a stroke’
Dennis Reed, founder of campaign group Silver Voices, voiced anger at the proposals. He said: “This is the most outlandish plan yet I have heard from the Treasury to deal with the problem of taxing the state pension.”
Such a “tax grab would increase pensioner poverty at a stroke, and cause immense physical and mental harm to vulnerable people. I cannot believe this plan will see the light of day, but if it does Labour can expect fireworks from all British pensioners,” he added.
A Government spokesperson said: “There has been no change to the tax treatment of the state pension. The Government routinely undertakes research to better understand pensioners’ experiences with the tax system.”
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