A plan to excuse pensioners from paying income tax if their only income is the state pension ‘risks being unfair and unworkable’, according to former Pensions Minister Steve Webb.
Some older people could be let off paying £58 in a scenario where the state pension is hiked 2.5 per cent in spring 2027, he says.
‘The Chancellor has said that HMRC will not collect the tax in this situation and will not do so in 2028/29 and 2029/30 either. But this proposal raises several questions of fairness.’
The Government announced in the Budget it is going to explore ways to avoid pensioners having to pay a small amount of tax should the state pension start exceeding the personal allowance from 2027/28.
The full flat rate will increase 4.8 per cent to £12,548 a year from next April, just nudging the threshold where people start being stung for income tax, which is £12,570 – and is set to be frozen until at least 2030/31.
That puts the Government in a bind, because if it keeps its popular triple lock promise to increase the state pension by at least 2.5 per cent a year, that will tip it over the threshold in April 2027.
But escaping this problem by exempting certain pensioners from income tax could create new unfairness and complexity, claims Webb, who is now a partner at LCP and This is Money’s retirement columnist.
Rachel Reeves: Government will try to avoid pensioners having to pay a small amount of tax due to income tax threshold freeze
A 2.5 per cent rise would make the state pension £12,862 in 2027/28, so someone with this income only would have taxable income over the threshold of £292 per year, and face tax bill of around £58.
The triple lock pledge means the state pension should increase every year by the highest of inflation average earnings growth or 2.5 per cent.
So it could go up more than that – and make the mooted tax reprieve more generous for some pensioners.
Meanwhile, many pensioners already receive a state pension over the £12,570 personal allowance, landing them with an income tax bill if they earned state pension top-ups during their working life or delayed taking the payments at state retirement age.
Those who built up even a small private pension also pay income tax already.
‘The Government has a clear presentation problem when the new state pension goes above the tax threshold in 2027,’ says Webb.
‘But millions of pensioners already get state pensions above the tax threshold and nothing has so far been done for them. So there is a real risk that pensioners on the new system will be more favourably treated.
‘The new scheme also risks penalising people with small private pensions who will not be protected compared with those who have no private pension who will be protected.
‘This penalises those who have saved, even modest amounts. And the new rules will mean that a pensioner just above the tax threshold will pay no tax whilst an employee on exactly the same income will pay both tax and NICs which seems unfair.
‘There is no costing for this policy in the Budget documents which suggests that it is still very much an idea rather than a firm plan. But it will be incredibly difficult for the Treasury to come up with something that is workable and fair.’
Webb has estimated that ten million pensioners could be paying income tax by end of the decade as a result of the threshold freeze, up from 8.7million now.
A Treasury spokesperson said: ‘As the Chancellor has said, over this Parliament those whose only income is the basic or new state pension without any increments will not have to pay income tax.’
Webb highlights problems with income tax exemption
Webb says the Government’s proposal raises the following questions about fairness.
1) What about people on the ‘old’ state pension who make up the majority of pensioners
There are currently around 2.5million pensioners on the old system whose state pension on its own is *already* over the tax threshold, he says.
Why has nothing been done for them so far? What will happen to people whose total state pension under the old system (basic pension plus Serps pension) is exactly the same as the rate of the new state pension – will they be exempt as well? What about if they are a pound above – do they continue to be taxed?
2) What about people with small private pension income?
The Government has said that this exemption would only apply to people with *no* other income aside from the state pension.
So would someone with £5 per week of private pension income face full taxation, but someone without would pay not tax?
Will this result in some people choosing to cash out their small private pensions rather than turn them into income which could cause them to lose the tax exemption?
3) What about workers on exactly the same income?
It is being proposed that a pensioner on (say) £12,862 should pay not tax, but an employee on exactly the same income would not get such an exemption – they would pay both tax and National Insurance contributions on their wage – why?
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