How to avoid the state pension tax trap

Millions will benefit from the triple lock – but it’s not all good news for those who have retired, Rob White reports

From today, more than 12 million retirees will receive an 8.5pc boost to their state pension thanks to the “triple lock”. It means an extra £700 a year for everyone claiming the full old “basic” state pension and around £900 more for those on the full new post-2016 state pension. This marks the second biggest rise since the triple lock was put in place in 2011- 12, behind last year’s record increase of 10.1pc.

Yet it’s not all good news for those who have retired.

A significant amount of what most gain will instantly be clawed back in tax, thanks to the Government’s stealth tax rises, sometimes called fiscal drag, that means more than half a million pensioners will be pulled into income tax for the first time.

They also won’t benefit from the 2p cut in National Insurance – the second cut this year – as those in receipt of state pensions do not pay NI. Others may also lose the £ 252-a-year marriage allowance, which cannot be claimed once one spouse becomes a higher-rate payer.

It comes as research shows that the state pension already leaves millions of pensioners facing six-figure shortfalls to reach even the most basic retirement.

HOW MUCH MORE WILL I GET

– AND WHY?

The triple lock, introduced by the coalition government, took effect in the 2011-12 tax year. It guaranteed that the state pension would increase annually by the highest of inflation, average earnings growth or 2.5pc.

From today, the basic state pension will rise by £13.30 a week, or £692 a year, and the “new” state pension, paid to anyone retired since April 2016, will jump by £17.30 a week, or around £900 a year.

The total amounts paid out each year are now £8,814 and £11,502. With the average pensioner couple earning £564 a week, and singles just £267, it represents around a 6pc boost to the average budget.

ARE STATE PENSIONS TAXABLE? The state pension is paid “gross”, with no tax taken off. The full amount is rising but still falls below the personal ( tax- free) allowance of £12,570 a year.

However, state pension income does count towards the allowance, and the threshold is frozen until April 2028. It will only take a small amount of income from other sources to tip you into paying tax, or breaking into a higher tax threshold.

BE AWARE OF TAX BRACKETS Anything you earn below £12,570 is usually tax-free. If you earn between £12,570 and £50,270, you will pay a rate of 20pc. The higher rate is levied at 40pc on anything between £50,271 and £125,140, then you pay 45pc on anything over that. You also need to watch how near you are to the next tax bracket. If you earn close to £50,270, a £900 increase could push you into the next rate, meaning you start losing 40pc to tax.

In addition, for every £2 you earn over £ 100,000, your personal allowance reduces by £1, which will also inflate your tax bill. For example, if you earned £99,999, the £900 would take you to £100,899 and remove £449 of your personal allowance.

Not only would you pay 40pc tax on earnings over £100,000, you also pay that on the £449 of lost allowance. This leaves you with £360 of the original £900 boost, meaning you have paid 60pc in tax.

TAKE YOUR TIME ON PRIVATE PENSION WITHDRAWALS

The increase in the state pension might mean you don’t need to start drawing all, or any, of your private pensions yet. This can cut your tax bill and give your pension longer to grow – unspent money left in a pension is free of inheritance tax, unlike cash in a bank account or Isa. Annuities linked to inflation and “defined benefit” pensions, often known as final salary pensions, will increase too. You should factor this into any decisions.

There’s also the option of spreading out your tax-free lump sum.

TAKE LESS FROM YOUR DRAWDOWN Once your pension is in a “drawdown” account you can withdraw from your fund when you need to. This is subject to income tax, but since you are in charge of how much you take out and when, you control how much tax you pay. If you are living comfortably on a set amount, you could reduce your drawdowns by the same amount that the state pension increases.

Not only do you avoid tax on money you don’t need yet, you can also leave that money in your account, meaning it will