The freeze on income tax thresholds will hit some pensioners harder than others, with those holding defined benefit, or 'final salary', workplace pensions having fewer options to reduce the impact. The tax-free personal allowance is currently frozen at £12,570 until April 2031, which will push more than 9.5 million pensioners into paying basic rate 20% income tax, while more of them could exceed the 40% higher rate threshold of £50,270.
State pension near the threshold
The maximum new state pension is now £12,547, putting it just £23 below the personal allowance, and it's expected to exceed it next year. Chancellor John Healey has promised that anyone whose only income is the state pension will not have to pay income tax. However, this does not cover all pension income. It excludes basic state pension increments such as SERPS and the State Second Pension, which will remain taxable.
Many retirees will look for ways to manage their income, using different sources of money to avoid unnecessarily crossing higher thresholds. Someone with a defined contribution pension can easily adjust the amount they take in a particular year and make careful tax-free cash withdrawals. Those with a final salary pension have less flexibility.
Challenges with final salary pensions
Final salary pensions are sometimes called 'gold-plated' because they offer a guaranteed, inflation-linked income for life, but they can be harder to manage from a tax perspective, said Des Cooney, a retirement planning specialist at Axis Financial Consultants.
“Pensioners with a defined benefit scheme might find the threshold freeze especially challenging since the income is usually fixed and taxable for life. In contrast to defined contribution withdrawals, the income usually cannot be reduced or deferred to stay within the personal allowance.”
Many will get caught out. “Once added to the state pension, even a relatively small workplace pension could tip your income above the personal allowance,” Cooney said. The state pension counts towards your taxable income, but HMRC doesn't deduct income tax from it directly. “Instead, it may recoup the tax by adjusting the PAYE code on the defined benefit pension.”
Tax-free cash and planning
This can come as a nasty surprise. A retiree may see their company pension payment fall and assume something has gone wrong, when HMRC is simply collecting tax owed on their overall income. “It looks like double taxation of the workplace pension, but in reality, the pension serves as the collection place for tax on your total income,” Cooney said.
Another area where final salary pension holders have less flexibility is tax-free cash. Andrew King, pensions specialist at wealth manager Evelyn Partners, said defined benefit schemes do give members the option to exchange some of their annual pension for a tax-free lump sum, but there is a drawback. “Final salary pension income is inflation-proofed, so getting a lower starting income will reduce the long-term benefits.”
As the tax threshold freeze drags on, pensioners need to understand how their different sources of income interact and plan withdrawals carefully to avoid unnecessary tax bills. If it all becomes too complicated, it may be worth considering financial advice.
