Chancellor John Healey introduced a new tax allowance for pensioners in Wednesday’s Budget, designd to ensure that pensioners living only on the state pension are not dragged into tax.
According to Stefanie Tremain of leading tax advisory firm Blick Rothenberg, details published by the Treasury show the allowance is “designed to do exactly what it says on the tin and nothing more” – protecting pensioners whose only income is the state pension from paying income tax.
But what about pensioners who’s partners have a separate income, or are only just above the tax allowance? Let’s take a look at how it works, who gains, who loses out and who will see little difference under the new system.
How does it work?
From next April, the full new state pension rises to £13,036 a year.
That takes it above the personal allowance, the amount you can earn before paying income tax, which has been frozen at £12,570 since 2021.
“A key point is that although it is being called an allowance, this is a tax reduction, not an extra allowance,” Tremain said.
Rather than raising the amount you can earn tax-free, it knocks up to £94 off your income tax bill once that bill has been worked out. But with the tax allowance frozen until 2031, this figure will rise each year.
For anyone with income above the £13,036 full state pension, the reduction is gradually withdrawn.
They lose £1 of it for every £3 of extra income, so the £94 is used up completely by the time their income reaches £13,319.
Tremain said this “does not work in the same way as the tapering to the main personal allowance”, which only affects people earning more than £100,000.
What is still unclear?
Tremain said: “It’s also not clear how the [pensions tax allowance] will interact with other tax allowances such as the trading allowance and the savings allowance.”
The Government’s factsheet suggests the new allowance will apply to total income – all your taxable income added together – which is normally calculated after those allowances are deducted.
If the pensions tax allowance is meant to apply first, she warned, “this would alter the existing ordering rules and will probably lead to some incorrect tax bills, particularly given HMRC’s previous difficulties with the interaction of the personal savings allowance and dividend allowance”.
Who gains?
According to Tremain, two groups of pensioners stand to benefit.
State pensioner living alone with no other income: If the state pension is your only income, you should pay no tax on it, saving up to £94 a year.
Tremain said that “perhaps most importantly, there should be no requirement to interact with HMRC”.
State pensioner with no other income, living with a partner with income over the basic rate band: A partner above the basic rate band is a higher rate taxpayer.
Tremain said “overall the household would be better off by up to £94”, because eligibility depends only on the pensioner’s own income.
“The Treasury could have considered trying to factor in household income, as with the [high income child benefit charge] and the fact they have not is a welcome simplified approach,” she said.
Who loses?
Pensioners with other income on top of the state pension are the ones who could miss out.
State pensioner with investment income and other private pension income: If your total income is above £13,319, you will lose the allowance in full, and start to pay tax at the £12,570 threshold.
Tremain said the new allowance “is intended to ensure that pensioners on the lowest income do not pay tax on their state pension income, rather than exempting the state pension from tax altogether”, which “arguably would have been more straightforward”.
Those just below the cut-off face a tax trap because of the way the reduction is withdrawn.
Writing for The i Paper, former pensions minister Steve Webb, now a partner at consultancy LCP, said around 200,000 pensioners would fall within this band.
For each extra pound they receive, they pay 20p in income tax and lose 33p of the reduction – a marginal tax rate of 53 per cent.
The highest earners outside Scotland pay 45 per cent on each extra pound, which led Webb to write: “This does seem rather harsh.”
State pensioner with investment income (within savings allowance; and over savings allowance): “It’s currently unknown how the [pensions tax allowance] will interact with the savings allowance,” Tremain said.
If the £1,000 savings allowance for basic rate taxpayers is applied first, she said “pensioners with modest savings income of up to £1,000 could still benefit”.
But if the new allowance comes first, those whose interest pushes their income above £13,319 “could find themselves losing their pension related tax reducer”.
Who will see no change?
For some couples, the new rules are unlikely to make much difference.
State pensioner with no other income, living with a partner with income below the basic rate band: Where the lower earner’s state pension is below the personal allowance, they can still use the marriage allowance to transfer up to 10 per cent of it to a spouse or civil partner who is a basic rate taxpayer.
Tremain said that “there appears to be no option to transfer any unused [pensions tax allowance], as a household they should be no worse off”.
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