Chancellor John Healey reportedly plans to exempt the poorest state pensioners from income tax in Labour's Budget on Wednesday by raising their tax threshold to £13,036. However, there are fears that the oldest retirees could miss out on the relief, which is worth up to £770.
The higher threshold matches the full new state pension rate taking effect next April. Without the change, retirees relying solely on the state payment would pay income tax on it for the first time from next April as the annual amount breaches the £12,570 personal allowance.
Former chancellor Rachel Reeves announced the plan to keep state-pension-only retirees out of tax last year, and her successor Healey confirmed plans to go ahead with it. According to a report in The Times, the scheme will cost £200 million a year by 2030, and a former pensions minister warned it could create a "two tier" system.
Tax relief savings and personal allowance rules
The tax-free allowance for people relying solely on the state pension is expected to rise in line with the headline annual payment for the rest of this parliament, meaning they will not pay income tax until at least 2029.
According to pensions firm Standard Life, the policy could save those on just the state pension £93 in its first year and £770 if it remains in place by spring 2031, when the personal allowance freeze is set to end. That figure assumes the state pension rises by the minimum 2.5 per cent each year, and retirees could save more if the increases are larger.
Full details are yet to be announced, but retirees earning even £1 in private pension above their state payment look set to be excluded alongside older pensioners. For them and everyone else, the UK personal allowance, which is the annual income a person can receive before paying the 20 per cent basic rate of tax, remains at £12,570.
Pensioners who could miss out on the tax break
Under the triple lock guarantee, which raises payments by the highest of inflation, earnings growth or 2.5 per cent, the headline new state pension will rise by nearly £500 a year to £13,036 next April following a reported 3.9 per cent increase in line with wages. However, there are concerns the tax break might only cover under-75s on the new system introduced in spring 2016.
People who retired before spring 2016 on the old basic state pension will get a £7.20 weekly rise to £192.10, or around £10,000 a year, well below the tax threshold. However, many also receive substantial top-ups earned earlier in life under the State Second Pension (S2P) or the State Earnings-Related Pension Scheme (Serps), which often push them into paying income tax already and might not be protected. It is also unclear if exemptions will cover people receiving extra state pension after delaying their payments.
Warnings over a two-tier state pension system
Former Pensions Minister Ros Altmann warned the policy could create a "two tier" system for older and younger retirees. "[S2P and Serps] have never been protected by the triple lock and it is not clear that they will be given the same tax exemption as the younger pensioners on similar incomes," she said.
"The Budget may introduce an age penalty for pensioners in future. For those over 75 on the old state pension, the tax threshold may remain at the same level as for non pensioners, as it has always been," Altmann added. "If their income is just over £13,000 they will pay 20 per cent tax on the amount above the £12,570 tax threshold but under 75s in the new state pension receiving the same amount will be tax exempt."
Growing costs and private pension cliff edges
Pension industry experts say excluding private savers could create messy "cliff edges" and be seen as unfair by those who did "the right thing" and saved for old age. Former Pensions Minister Steve Webb, now a partner at pension consultants LCP and a columnist for This is Money, pointed to long-running threshold freezes.
"This scheme is being developed because the repeated freezing of the personal allowance has dragged more and more pensioners into the tax net," Webb said. "But the proposed solution looks messy and increasingly expensive. The gap between the new state pension and the tax threshold is set to grow every year, which will make the policy hard to switch off. But if it continues, the cost will grow and grow."
"If the extra allowance is available only to those on a low income, there could be a growing 'cliff edge' problem where those with very small amounts of private income lose the whole allowance and end up worse off than those with nothing," Webb added.
Patrick Thomson, head of policy at Standard Life Centre for the Future of Retirement, said the measure would still help qualifying retirees. "This will be a relief for those affected, avoiding both an unexpected tax bill and additional tax administration," he said.
"Much will depend on the detail of the protection and who qualifies. If it applies only to those whose sole income is the state pension, people with even relatively modest workplace or private pension income could still be affected," Thomson added. "What looks like a relatively simple solution could become more complicated over time as the state pension continues to rise against a frozen personal allowance, widening the difference in tax treatment between those relying on the state pension alone and those with relatively small amounts of additional retirement income."
Fairness concerns for savers and younger workers
Kate Smith, head of pensions at financial services provider Aegon, warned of the impact on workplace savers. "If these reports are confirmed, protecting those who rely solely on the state pension from paying income tax will be welcome news for some of the lowest-income pensioners," she said. "However, there is a risk that creating a more generous tax position for those who have not built up additional retirement savings could be seen as unfair by people who have had the means to do the right thing and saved through workplace and private pensions."
"Long-term pensions policy should be guided by fairness across generations and between different groups of savers, rather than short-term measures designed to fix one specific issue," Smith added. "Any reforms need to support adequacy, reward saving and command confidence across the whole retirement system."
Tom Selby, director of public policy at investment platform AJ Bell, noted reports that the government intended to match the personal allowance to the state pension for low-income retirees and raise them in sync for a period. "Reports of a 3.9 per cent state pension increase in line with wages will be a vital boost for pensioners worried about rising costs in 2027, but pushing it over the frozen personal allowance was always going to raise difficult questions," he said.
"While details remain thin on the ground, there is a danger in attempting to fulfil his predecessor Rachel Reeves' promise not to apply income tax to those who only receive state pension income, Healey creates a mess of complexity, odd incentives and obvious unfairness in the tax system," Selby added.
Selby said savers could understandably argue their diligent behaviour has effectively been punished if only state-pension-only retirees benefit, whereas a higher allowance for all pensioners would create a two-tier tax system explicitly favouring older people. "Given those already above state pension age do not pay National Insurance currently, creating a further income tax benefit for older people risks hardening perceptions of intergenerational unfairness," he said.
