The state pension went up 8.5% in April – hitting £11,502 per year for someone on a full new state pension. This is great news for people’s beleaguered budgets, after the cost of living crisis laid waste to their finances. With inflation finally on the wane, this increase introduces some much-needed breathing space.
However, many pensioners won’t be getting as much of this blockbusting increase as they first thought, because frozen tax thresholds threaten to claw back a bigger chunk of their income.
The personal allowance and higher rate thresholds have been frozen for some time and this looks set to continue until 2028. This, along with a reduction in the additional rate threshold, means pensioners will be paying more tax.
Read more: How to supercharge your pension this year
With the full new state pension currently only a whisper under the personal allowance of £12,570, it doesn’t take much extra income from a private pension or self-invested personal pension (SIPP) to tip people into tax-paying territory.
If the threshold remains as it is until 2028 then we don’t need to see particularly big annual increases before someone only in receipt of a full new state pension gets landed with a bill. According to the Liberal Democrats, by 2027-28, 1.6 million additional pensioners will be paying income tax compared to if the personal allowance had been increased in line with inflation.
How can you limit the impact of tax creep on your retirement income?
Don’t take large sums from your pension if possible
Don’t be tempted to take large chunks out of your pension without a specific reason for doing so, as you may find it inadvertently tips you over into the next tax bracket. You may also find you get charged at an emergency tax rate and have to claim money back. Plan any withdrawals in advance and you could save yourself some unwelcome bills.
Use your tax-free cash
You can also make use of the tax-free cash portion of your pension to keep your bill down. Most people can take 25% of their pension (up to £268,275) tax free. You can take it as a lump sum or through UFPLS whereby 25% of each withdrawal you take is tax free.
Look beyond pensions
Income from an ISA can be taken tax-free, so it could be a good strategy to either draw down your ISAs first or draw them alongside a smaller pension income to minimise tax.
Read more: Can you work into your 70s if the state pension age goes up?
Defer your state pension
You don’t receive your state pension automatically when you hit state pension age – you have to claim it. If you don’t need the extra income, then you can defer it. Under the new state pension rules, for every 9 weeks, you defer you will get an extra 1% in your state pension when you come to claim it.
This works out at just under 5.8% extra for every year you defer. However, you need to be aware that deferring your state pension today might lead to bigger tax bills tomorrow, as you would claim a larger amount.
Watch: What is pensions dashboard and how it will make retirement investment more transparent
