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We are a step closer to knowing how much the State Pension will rise by next year - but still don’t know for sure how the payment will be taxed.
The increase in the State Pension arriving in April 2027 is not quite confirmed - we need to wait a few more weeks for that - but it is likely to be around 4%, based on annual wage rises over the past year.
Wages have been the fastest rising of the three measures counted for the purposes of the ‘Triple Lock’. That’s the promise to raise the State Pension each year by the highest of either inflation, wage growth or 2.5%.
Officially, it is the annual rise in average total pay from the May-to-July period of the preceding year that is used in the Triple Lock calculation. We won’t know that until later in September but the April-to-June figure came in at 4.1% so a rise of around 4% looks likely.
That would take the full new State Pension from £241.30 a week to £251 a week. On an annual basis the payment would increase from £12,547.60 to £13,052 - a rise of £504.40.
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A tax headache in the making?
The keen-eyed may have noticed that a rise of that size would take the State Pension past an important tax milestone. Namely, the full new State Pension will exceed the Personal Allowance for income tax, which is currently £12,570. This is the amount of income you can normally earn before income tax applies. Currently, almost nobody for whom the State Pension is their only income has to pay tax (there are exceptions - as we’ll explain). But that could potentially change next year without government action.
This situation has long been predicted because, while the Triple Lock ensures the State Pension has been rising quickly (with no sign of a change in the policy), the Personal Allowance has been frozen since 2022, along with the other income tax thresholds.
The question is whether the government will collect the extra tax owed - and how?
Tax on the State Pension or the first time? Not quite
There are already signs of consternation that State Pensions face being taxed like this, but that reveals a common misunderstanding. The State Pension has always been liable to tax, it’s just that the State Pension alone generally doesn’t exceed the Personal Allowance.
The exception is the small number of people who receive a State Pension which exceeds the Personal Allowance, either because they have deferred theirs to get a higher payment or because they are eligible for higher payments under the old systems for Additional State Pension. If this is their only income, then they need to pay the tax due via ‘Simple Assessment’. This is the process which settles tax bills without the need for a full self-assessment tax return.
In previous years, when the Personal Allowance was significantly lower, there were age-related top-ups to the Personal Allowance which ensured no one living only on the State Pension paid tax. These top-ups were not available to those on higher incomes and were withdrawn completely in 2016 once the Personal Allowance rose to a level where no-one claiming them would pay tax anyway.
But I get a State Pension - and I pay tax already!
The vast majority of pensioners already pay income tax, of course, because they have income from private pensions on top of their State Pension. Any tax due can be handled through adjustments made by their private pension provider, based on a tax code provided to it by the government.
Importantly, even if their State Pension were to rise above the level of the Personal Allowance, it should be possible to deduct tax due via their private pension income in this way without the need for a Simple Assessment tax demand.
The problem arises in cases when State Pension is the only income and there is no private pension provider on hand to make deductions for tax.
Why can’t the government just pay people less?
You might ask why the government would pay people a State Pension only to then take a small part of it back in tax - couldn’t they just pay them less in the first place?
The answer is no, because the State Pension is paid gross of tax. There is no Pay-As-You-Earn system to tax the State Penson at source. The government has previously looked at creating one, back in 2013, but the plan was ruled out on the grounds of cost and complexity - it would have meant running a payroll scheme 10 times bigger than any private scheme dealt with by HMRC.
That would appear to leave the system of Simple Assessment as the only existing option for collecting income tax should it be payable by those who live only from the State Pension. Will the government do that?
Government ‘exploring’ what comes next
When then Chancellor Rachel Reeves extended the freeze of the Personal Allowance and other tax thresholds in the 2025 Budget, she addressed the issue of tax bills potentially becoming due for those living only on the State Pension.
The government would ensure, she said, that “people only in receipt of the Basic or New State Pension do not have to pay small amounts of tax through Simple Assessment from April 2027”.
That appeared to rule out Simple Assessment as a method to collect this tax and was widely interpreted as meaning the tax would simply be waived, for the length of this parliament at least.
There’s wisdom in that - campaigners at the Low Incomes Tax Reform Group warned last year that sending Simple Assessment tax demands to thousands of pensioners was likely to cause confusion and cashflow problems for people already struggling on low incomes, not to mention an avalanche of calls to HMRC.
Ruling that out makes sense, but there is an acknowledgement that a more lasting solution is needed. The Budget 2025 promised that “the government is exploring the best way to achieve this and will set out more detail next year”.
If the government decides to not collect this tax it risks creating a two-tier system: many pensioners can be taxed on their State Pension perfectly well because they have private pension income and a tax code. Would it be fair to deny them a waiver for paying tax on their State Pension? Bear in mind that they need only a very small private pension to be taxed this way, so they may not be much better off than others who get only the government payment.
Then is the potential intergenerational conflict, of pensioners being handed another break in a system which already advantages them compare with working age people.
The only alternative, if the government doesn’t want to start sending out tax demands en masse, is an expensive and cumbersome extension of PAYE to State Pensions.
Time is running out for the government to pick a solution.
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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. SIPP eligibility and tax treatment depends on individual circumstances and tax rules may change. You cannot normally access money in a pension until age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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