Understanding the Tax Implications of the State Pension
In our weekly series, we invite readers to submit their questions regarding retirement and pension saving, to be answered by our expert, Tom Selby, who serves as the director of public policy at investment platform AJ Bell. With extensive knowledge in the field of pensions, Tom is well-equipped to clarify any doubts you may have. If you have a question for him, please reach out to us at [email protected].
Question: I recently received a notification from HMRC concerning the upcoming tax year, which has left me quite perplexed. The notice states that the state pension is taxable, and I have always held the belief that it is not subject to taxation. More specifically, it mentions that state pension income ‘is taxable but tax is not deducted from the payments before they are disbursed to you’. I’m struggling to grasp what this truly means. Although I consider myself reasonably astute, this particular communication from HMRC has me baffled regarding how the tax is applied and what it signifies for my income in the future. Up until now, I have managed to understand all previous communications from HMRC without any issues.
Answer: Don’t be too hard on yourself for finding this confusing—understanding the state pension system in the UK can be incredibly complex, especially when it comes to how it interacts with the income tax landscape. To give you a clearer picture, the full ‘new’ state pension is currently valued at £221.20 per week, which amounts to approximately £11,500 annually. Starting from April 2025, the state pension is set to increase to £230.25 per week, almost reaching £12,000 per year, in accordance with the government’s ‘triple-lock’ commitment. This pledge guarantees that the state pension will rise by the highest of the average earnings growth, inflation, or a minimum of 2.5 percent. Individuals become eligible to receive the state pension at age 66, with plans in place to raise the state pension age to 67 by 2028 and 68 by 2046.
When it comes to taxation, your state pension does indeed count towards your overall income for income tax purposes, but it is not taxed directly at the point of payment. In technical terms, you may hear that the payment is made ‘net of tax,’ which simply means that no income tax is deducted before you receive your payment.
To illustrate how this works, let’s consider an example. Suppose someone has not accumulated a 35-year National Insurance record, which is necessary to qualify for the full state pension amount, and as a result, they receive a reduced state pension of £9,000 per year. Although no tax will be deducted directly from this income, it still consumes £9,000 of their personal allowance (the threshold below which the income tax rate is 0 percent), which is set to be £12,570 for the tax year 2024/25.
- If this individual then withdraws an additional £5,000 from their private pension during the same tax year, the first £3,570 will be taxed at 0 percent, while the remaining £1,430 will be taxed at 20 percent (the basic income tax rate). Consequently, they would end up owing a total of £286 in income tax.
Strategically managing pension withdrawals around these income tax thresholds can be an effective way to minimize your overall tax liability. In the example provided, had the individual opted to distribute their £5,000 private pension income into smaller portions (say, £1,000 each) across different tax years, they could have remained below the £12,570 personal allowance. This would have allowed them to avoid income tax entirely, resulting in a potential savings of £286 (assuming the personal allowance remains unchanged at £12,570). While this strategy may not be feasible in all situations, it’s certainly a consideration worth keeping in mind when planning pension withdrawals.
What happens if your state pension exceeds the personal allowance?
The combination of the frozen personal allowance and the government’s triple-lock commitment indicates that we are nearing a time when the full new state pension will surpass the personal allowance threshold. In fact, analysis from actuarial firm LCP reveals that there are currently 2.6 million individuals receiving state pension payments that exceed £12,570 (largely due to entitlements accrued under the ‘old’ state pension system prior to 2016), and this number is anticipated to rise in the coming years. You may recall former Prime Minister Rishi Sunak mentioning a ‘retirement tax’ during his campaign—this is precisely what he was referring to. His proposed solution involved linking the triple-lock pledge to the personal allowance for retirees.
This situation presents practical challenges for both retirees and HMRC, as an increasing number of individuals find themselves with only state pension income that exceeds the personal allowance. Since the state pension is disbursed net of tax, HMRC is required to send tax demands to retirees in this scenario, as there are no alternative sources of income from which to collect the tax owed. This is referred to as a ‘Simple Assessment’ tax bill. Therefore, anyone receiving a state pension that surpasses the personal allowance should be prepared to receive a tax demand in the mail. For instance, if you have a state pension of £13,000, you should anticipate a tax bill of £86 at the end of the tax year.
It’s also a potential political challenge for the government. However, it is important to note that even after accounting for income tax, the triple-lock pledge continues to serve as a valuable assurance that state pension incomes will experience annual increases.
