State pensioners warned over 20 per cent tax trap from April payment rise

State pensioners are being warned of a 20 per cent tax trap they could fall into after the next payment increase comes into effect. Around two-thirds of retirees already have to pay tax, and the new amounts of State Pension are rising ever closer to the HMRC Personal Allowance, where income tax liability begins.

Government documents on the Chancellor's Budget say: "To help make sure pensioners are protected in their retirement, we have also confirmed a 4.1 per cent increase to the Basic and New State Pension, as well as the standard minimum guarantee for Pension Credit, from April next year.

"Over 12 million pensioners will benefit as the full New State Pension will rise from £221.20 to £230.25 a week, providing an extra £470 a year. The full basic State Pension will increase from £169.50 to £176.45 per week, worth an extra £360 annually."

However, the new increases push both levels of the State Pension nearer to the Personal Allowance for income tax, which is £12,570. Based on the new rates, the Basic State Pension will be going up to the equivalent of £9,175.40 annually and the New State Pension to £11,973 a year.

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This means someone on the New State Pension alone will end up just £597 a year below the tax threshold from April 2025. Those only on the Basic State Pension will be £3,394.60 a year under the threshold.

However, many older pensioners get extra from previous government schemes that were available before April 2016. These are together known as Additional State Pension and there are three types: State Second Pension which ran from 2002 to 2016, State Earnings Related Pension Scheme or SERPS (1978-2002), and State Pension top-up (2015-2017).

Anyone on the New State Pension who is getting any other income that's more than £597 a year - or just £49.75 more a month - will find themselves having to pay a tax bill the following year. Someone on the Basic State Pension who receives an Additional State Pension or other pensions that amount to more than £3,394.60 will also face a tax bill from this so-called 'fiscal drag' caused by the personal threshold remaining frozen while income levels go up.

The amount due is calculated by totting up taxable income from all sources including the State Pension, and charging tax on the amount above the £12,570 allowance. Income tax of 20 per cent is then deducted from any private or workplace pension or any other earnings you might have. In some cases, you may have to complete a self-assessment form and pay any tax directly.

Pension Age says the number of people over State Pension age paying income tax has risen by 660,000 from 7.85 million in 2023/24 to 8.51 million in 2024/25, according to HMRC data. This means 68 per cent of pensioners are already forced to pay income tax.

The vast majority of these are older pensioners on the pre-2016 pension system, where it was possible to significantly increase the amount by combining their Basic State Pension with extra such as SERPS. Others may have a private or workplace pension that boosts the amount they receive.

Spencer Churchill predicts nearly 900,000 more people will exceed the Personal Allowance threshold of £12,570 over the current financial year of 2024-2025, with a further two million set to be taxed before the current freeze on the levels of the allowance is set to end in 2028.

Some have dubbed it a stealth tax because the government includes the State Pension in the calculations. There have been calls for tax to apply only to the total amount of private or workplace pensions that are above the level of the allowance.

What the government said about taxing pensions

In response to a petition, the Treasury had previously said it had no plans to make the State Pension non-taxable. It said: "The personal allowance is high enough that pensioners whose sole income is the New or Basic State Pension do not pay income tax. The State Pension is designed to replace income and so is taxable. The Government is committed to ensuring that older people are able to live with the dignity and respect they deserve.

"Income earned through employment is taxable. In general, benefits that are designed to replace income are taxable and the same applies to income from the State Pension. Income tax is due on an individual's total income above the personal allowance, currently £12,570. Total income could include: the State Pension (the Basic State Pension, the New State Pension, and the Additional State Pension); other taxable benefits; a private pension (workplace or personal); any other income, such as money from investments, property, or savings.

"It is important to note that the personal allowance is currently set at a level high enough to ensure that those pensioners whose sole income is the New State Pension or Basic State Pension do not pay any income tax. The Government has nearly doubled the personal allowance since 2010 meaning around 30 per cent of individuals do not pay any tax. If the personal allowance had been uprated by inflation every year since 2010-11, it would be £9,655 in 2023-24, which is £2,915 lower than its current level of £12,570."

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