Could you lose out on tax-free allowances for other income?
Many pensioners will enjoy another uplift in their State Pension income next financial year. From 6 April 2025, the State Pension is due to rise by 4.1%, on the back of an 8.5% increase in April 2023. This growth adheres to the government’s ‘triple lock’ policy, which ensures that the State Pension increases annually by the highest of wage growth, inflation or 2.5%. However, this rise also brings potential complications for some retirees.
The increase will elevate the full new state pension from £11,502 in the 2024/25 tax year to £11,976 in 2025/26. While this rise will be welcome for many, the frozen Income Tax personal allowance, held steady at £12,570 until April 2028, could be a pitfall for pensioners with additional income sources. It could result in losing out on tax-free allowances for other income, like savings or rental profits, and create unexpected tax liabilities.
How rising pensions affect taxable income
For those who rely solely on their State Pension, no tax is payable if their income stays within the personal allowance. However, pensioners with extra income, such as private pensions, annuities or rental income, will need to monitor their earnings closely. Once the total exceeds the £12,570 threshold, any income above this limit becomes taxable.
The scenario could worsen in years to come. If the State Pension increases by two annual 2.5% hikes after 2025, it could surpass the Income Tax personal allowance within the 2027/28 tax year. As a result, many retirees may find themselves paying Income Tax on their entire State Pension sooner than expected.
Tax bands and the impact on retirement income
The basic tax rate for 2024/25 is set at 20% for income above the personal allowance, up to £50,270. Any income beyond that is taxed at the higher rate of 40%, while earnings above £125,140 incur an additional rate of 45%. These thresholds apply to most parts of the UK, though Scottish taxpayers face different tax rates and bands.
Fortunately, there are strategies to help retirees manage their tax liabilities. For instance, basic rate taxpayers benefit from a personal savings allowance of up to £1,000 in 2024/25, while higher rate taxpayers have a reduced allowance of £500. The ‘starting rate’ band for savings income also allows those with low overall taxable income to earn up to £5,000 in savings Income Tax-free.
Maximising tax-free allowances
Even modest tax savings can make a significant difference over the long term. Dividend income, for example, enjoys its own allowance, which lets investors receive £500 tax-free in 2024/25. Although this figure has been reduced from £1,000 in the previous tax year, it still provides an opportunity to shelter some earnings.
Tax-efficient vehicles, such as Individual Savings Accounts (ISAs), can also play a critical role in retirement planning. By investing in a Cash ISA or a Stocks & Shares ISA, pensioners can enjoy income and capital gains free from taxation, allowing their savings to grow unrestricted. National Savings and Investments (NS&I) also offers tax-free products like Premium Bonds, which combine strong security with the potential for large, tax-free cash prizes.
Managing pension income and withdrawal strategy
Accessing private pensions requires careful planning to avoid unnecessary tax burdens. Retirees can withdraw 25% of their pension pot tax-free, but it’s wise to spread taxable income over multiple years to remain in a lower tax band. For example, withdrawing smaller amounts across several tax years can prevent triggering higher tax rates.
Stocks & Shares ISAs remain a valuable tool for income supplementation. Unlike pensions, withdrawing money from an ISA doesn’t incur additional tax, making it a highly flexible option for retirees looking to bridge income gaps or support long-term needs.
Deferring the State Pension for long-term gain
Deciding when to claim the State Pension is another critical choice. Deferring receipt can increase the eventual payout, which may be especially beneficial for those still working or expecting reduced income later in life. However, the decision depends on factors like life expectancy and projected financial needs.
For those in a marital or registered civil partnership, income-splitting can be a smart move. Allocating assets or investments to the lower-earning partner can reduce overall tax liability. Additionally, matching asset types to accounts – such as using ISAs for dividend-yielding investments – can maximise tax efficiency in retirement.
Planning for a tax-efficient retirement
Effective financial planning can help pensioners fully to utilise their allowances and options. Proactive steps, such as reducing taxable income with ISAs or leveraging allowances for savings and dividends, can make a substantial difference. Understanding your situation and adjusting your strategy regularly is essential for avoiding potential tax pitfalls.
THIS ARTICLE DOES NOT CONSTITUTE TAX, LEGAL OR FINANCIAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.
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