‘Vast majority of pensioners’ set to miss out on government concession on state pension and tax – Steve Webb, LCP

New research published today by pension experts at LCP shows that the vast majority of Britain’s pensioners will not be eligible for the Government’s plans to exempt certain pensioners from income tax from 2027.

In April 2027, it is expected by the Government that the standard rate of the new state pension – currently £12,548 per year – will exceed the income tax threshold – currently £12,570 and set to remain frozen until 2030. At this point, someone wholly dependent on the new state pension would start to get an annual tax bill from HMRC via the ‘Simple Assessment’ process, though they would not need to file a tax return. In 2027/28, the bill would be around £88, in 2028/29, around £153 and in 2029/30, around £220.

To avoid such bills being issued, the Chancellor announced in the Budget that there would be a special scheme so that, for the rest of this Parliament, no one in this position would be charged income tax.  

The Budget Red Book said:

The Government has subsequently clarified that this is not simply an ‘administrative’ easement, but that pensioners in this position will not be charged tax at all.

However, of the 13.2 million people currently receiving a state pension, the new LCP research suggests fewer than 1 million will be covered by this pledge.

In particular:

• None of the 7.7m pensioners on the old state pension system will qualify - this is because the concession says that such pensioners would only be relevant if their sole income was the old basic state pension ‘with no increments’; but the current rate of the basic state pension is £9,614 per year and will be nowhere near the tax threshold of £12,570 by the end of this Parliament. This means someone wholly dependent on the old basic pension scheme could not qualify. Whilst the majority of people on the old system also get ‘additional’ state pension (around 6.5m) and so might well have income tax to pay, they will automatically be debarred from the proposed concession because they receive ‘increments’ on top of the basic pension.
• Out of around 5.0m people on the new state pension, more than 4 in 5 would not qualify, because:
  • Around 0.29m are not based in the UK;
  • Of the remainder, around 1.0m receive ‘increments’ on top of the new state pension (known as ‘protected payment’);
  • Of the remainder, around 1.1m have a rate of New State Pension too low to go above the tax threshold in the next three years;
  • Of the remainder, around 1.8m have other taxable income (such as private pensions or investment income), which means they are not ‘solely’ dependent on the state pension;

This leaves around 0.7m potentially benefiting from the concession, or only around 5% of all pensioners.

The LCP report identifies a number of serious problems with what is proposed. The key ones are:

• Differential treatment of old and new state pensioners: someone who simply has a new state pension above the tax threshold in 2027/28 will have their tax bill wiped; but someone on the old system with a basic plus additional state pension of exactly the same value will have to pay tax; (this is because they are not ‘solely dependent’ on the old basic pension);
• Cliff edge for those with £1 of other income: someone who qualifies for the easement in 2027/28 does not have to pay tax but someone who just misses out because of £1 of other income (or a similarly trivial ‘increment’) will have to pay income tax not just on the £1, but also the income tax on their state pension – a further £88. Over time, this cliff edge will increase, from £153 in 2028/29 to £220 in 2029/30.
• Interaction with Automatic Enrolment: If someone is enrolled into a workplace pension and builds up a small pension pot which they cash out in full, they will have 25% tax free but pay tax on the other 75%; if they do this alongside drawing a standard new flat rate pension then presumably they will be treated as not being ‘solely’ dependent on the state pension, and therefore not eligible for the concession; accessing a small pension pot in full could cost them hundreds of pounds in extra tax by 2029/30.
• What happens next? – this policy is clearly something of a ‘sticking plaster’ to run up to the next Election; but whoever wins the next Election will then need to work out what to do in future years; it may be reasonably easy to defend not collecting (say) £88 in tax from relatively low income pensioners in year 1, but as the years go by the Government would be writing off hundreds of pounds per eligible pensioner per year, at a growing cost to the taxpayer and an every greater disparity to those with modest other income; at some point a more durable solution will need to be found.

The paper then looks at potential ways of addressing this issue, which might not suffer from some of these problems.

One option is an across-the-board increase in the tax allowance for pensioners, so that someone wholly dependent on the new state pension would be under the tax threshold. The problem is that this would be a windfall to all taxpaying pensioners, including the 8.7m who already pay tax this year. As a result, the cost by 2029/30 could exceed £2bn per year, and is likely to be unaffordable.

A second, more limited, approach would be to simply write off small tax bills for pensioners, however they arose. For example, it is likely that someone solely dependent on the new state pension would pay around £88 in tax in 2027/28. One option would be simply not to issue ‘simple assessment’ tax demands for any pensioner with a bill at or around this figure. This would remove the differential treatment between people on the old and new state pension systems. But it would still be subject to potential cliff edges if people had small amounts of taxable income, which took them above this de minimis figure.

Commenting, Steve Webb, Partner at LCP, said: 

“Two separate policies – triple lock uprating of the state pension and freezing of tax thresholds – will collide next year. From 2027 onwards, someone with just the new state pension and no other income will start getting annual tax bills from HMRC. This is politically embarrassing for the Government, but the proposed solution is deeply flawed. It discriminates against those on the old state pension system, even if they have the same income as someone on the new system, and creates unwelcome ‘cliff edges’ for those who have even a pound of other income. It is also clearly a temporary sticking plaster solution for a problem that will have to be addressed at some point. A general write-off when people have small amounts of tax would probably be a cleaner solution, though a more fundamental review of pension and tax allowance levels is clearly needed.”

Alasdair Mayes, Partner and Head of Pensions Tax at LCP, added:

“This is another example of a seemingly well-intentioned policy announcement adding complexity and unfairness in the tax system. A simple and transparent tax system would be a benefit to all.”