Will YOU be let off tax on your state pension? ‘Deeply flawed’ plan will exempt one out of 18 pensioners, says Steve Webb

The Government’s plan to let older people off paying income tax if their only income is the state pension will benefit just one in 18 pensioners, a new report has found.

No one who reached state pension age before April 2016 will be excused, and nor will younger pensioners with even £1 of private income on top of the state pension.

The ‘sticking plaster solution’ to the full state pension starting to exceed the basic income tax threshold from next spring is ‘deeply flawed’, says former Pensions Minister Steve Webb.

‘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.’

Out of 13.2million people currently receiving a state pension, around 700,000 could be spared a tax bill starting next year, according to the report from LCP, where Webb is a partner.

It estimates that someone wholly dependent on the new state pension would be let off around £88 a year in 2027/28, £153 in 2028/29, and £220 in 2029/30.

The plan could drive a wedge between pensioners who are exempt and those still expected to stump up tax, and get increasingly expensive – yet be hard to ditch.

Webb says: It may be reasonably easy to defend not collecting, say, £88 in tax from relatively low income pensioners in year one.

‘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 ever greater disparity to those with modest other income. At some point a more durable solution will need to be found.’

The Government announced in the last Budget it wanted to avoid pensioners having to pay a small amount of tax when the headline state pension rate overtakes the personal allowance from 2027/28.

The annual full rate new state pension for those retiring since 2016 is currently £12,548 a year. That just nudges the threshold where people start being stung for income tax, which is £12,570 and is set to be frozen until at least 2030/31.

This puts the Government in a bind, because if it keeps its popular triple lock promise to increase the state pension by at least 2.5 per cent a year, that will tip it over the basic rate tax threshold starting next spring.

But the LCP report points out a number of holes in the plan to get around this by not taxing people whose only income is the new state pension.

1. None of the 8.1million people receiving the old state pension will qualify. It is a two tier system, and the basic element which is what will count is £9,614 a year – well under the £12,570 personal allowance.

Some 6.5million of these pensioners also receive top-ups, known as S2P and Serps, earned during their working life, but they would not qualify for the income tax exemption either.

Someone on the old system with a basic plus additional state pension of exactly the same value as the new state pension will have to pay tax, because they are not ‘solely dependent’ on the old basic pension.

2. Out of the 5 million people receiving the new state pension, four out of five will be ineligible to have tax waived, mostly because they have other income from private pensions or investments.

Others receive ‘protected payments’ earned under the pre-2016 state pension system, or are receiving too little state pension to reach the income tax threshold.

3. There will be a cliff edge for those with just £1 of other income, meaning someone would have to pay income tax not just on the £1, but also on their state pension.

4. If someone builds up a small private pension which they cash out in full, they will have 25 per cent tax free but pay tax on the other 75 per cent, so under the rules as revealed so far they would be treated as not being ‘solely’ dependent on the state pension.

LCP looked at other possible solutions but found they also came up short.

One idea is an across-the-board increase in pensioner tax allowances, but this would get more expensive every year and the bill could run into billions of pounds so seems unlikely, says the firm.

Its report also explores a general write-off of small income tax bills, which would be more targeted and would treat pensioners on the old and new system the same, but still risk creating cliff edges and unfairness.

Webb, who is This is Money’s retirement columnist, says: ‘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 identical income to someone on the new system, and creates unwelcome ‘cliff edges’ for those who have even a pound of other income.’

Webb adds that the Government’s plan is 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,’ he says.

The Government was asked for comment on the LCP report, and a Treasury spokesperson said: ‘Anyone whose only income is the full new or basic state pension without any increments will not pay income tax and we are committed to that over this parliament.

‘By keeping the triple lock, 12 million pensioners will see their income rise by up to £470 this year, and they continue to benefit from the highest personal allowance in the G7.’