State pensioners could face an unexpected tax bill from HMRC this year, even if they only have modest savings. Many people mistakenly believe that state pension income is tax-free, but it is subject to the same tax rules as any other income.
The warning applies even after the special tax exemption announced by Prime Minister Andy Burnham, because only pensioners with no other income will be exempt from Income Tax. Those with other income, including a private pension, will be taxed as normal.
Small savings can cross the tax threshold
The new full state pension is around £12,547 a year for someone with a full National Insurance record, while the Personal Allowance stands at £12,570, where it will remain frozen until 2031. That means earning just £23 a year on top of the state pension makes a pensioner liable for some tax, before the next triple lock increase.
Income that counts towards the tax bill includes paid work, self-employment, savings interest and private pensions. An annuity offers a 25% tax-free lump sum, but regular annual income from the annuity is taxable. Further withdrawals from a private pension pot, whether as income drawdown or a larger lump sum, are also taxed.
How savings interest pushes pensioners over the limit
For example, £1,000 in a savings account at 4% interest generates £40 a year, pushing a pensioner £17 over the £12,570 threshold. £10,000 at 4% generates £400 annually, of which £377 is taxable at 20%, producing a £75 tax bill.
The Starting Rate for Savings can give tax-free interest on up to £5,000 of savings interest, but only for those whose other income is below £17,570. The government says: "You may also get up to £5,000 of interest and not have to pay tax on it. This is your starting rate for savings. The more you earn from other income (for example your wages or pension), the less your starting rate for savings will be."
What pensioners should know about pension tax
Money Helper warns that pension income, including the State Pension, is still taxed after retirement. Even though the State Pension is paid without tax deducted, tax is still due and is usually collected through any personal or workplace pension.
In its guidance, Money Helper says: "After you’ve retired, you still have to pay Income Tax on any income over your Personal Allowance. This applies to all your pension income, including the State Pension. Many people assume that their pension income – especially the State Pension – will be tax-free, but that’s not the case. Some income, including your State Pension, is paid without any tax being taken off. But it doesn’t mean that tax isn’t due. If you have to pay tax on your State Pension, this will usually be collected through any personal or workplace pension you might have. When you’ve reached the age you’re allowed to access it you can take money out of your pension as and when you want. However, usually only the first 25 percent will be tax-free. The rest is taxable as earnings. The tax rate you pay increases when your income goes over the income tax thresholds. This means that the more money you take from your pension pot, the higher your tax bill could be."
Charity calls for clarity on exemption
Morgan Vine, Director of Policy at charity Independent Age, warned that the exemption could create an unfair outcome, with some pensioners on similar incomes treated differently. She said: "Different versions of the State Pension mean some older people receiving a lower State Pension and a small private pension would be dragged into the tax system, while others receiving only the State Pension will be exempt, despite the amount they receive being largely the same. Clearly, this is a situation that needs to be addressed so no older person on a low income loses out. Every day we hear from older people with chronic money worries who are making difficult decisions to make ends meet, from rationing their energy and water use to skipping meals. We look forward to receiving clarity from the UK Government on how the State Pension tax exemption will work to protect all pensioners on low incomes."
