Understanding Tax Creep in Retirement
On 6 April 2024, the full new State Pension amount rose to £221.20 a week – an increase of 8.5% on the previous year. This may be welcome news if you’re a retiree or pay retiree tax since the State Pension could supplement your income from other sources.
You also receive the payments for the rest of your life, so the State Pension could be a valuable source of income throughout retirement. However, the rise in State Pension payments could mean that you’re more likely to be affected by “tax creep”. This happens when tax thresholds remain frozen but your income increases, pulling more of your wealth into the taxable range.
Read on to learn how tax creep could affect you and what you could do about it.
How Tax Creep Affects Your Retirement Income?
Does Tax Creep Affect Retirees?
1.6 million more pensioners are expected to pay Income Tax by 2027/28
Your “Personal Allowance” – the amount you can earn before paying Income Tax – is £12,570 for the 2024/25 financial year. It has been at this level since 2021/22 and the government announced that it will remain at this level until at least 2028, however, this could change, if there is a change of government in the general election this year.
For the latest state pension information, please read our Budget roundup here.
What is retirement tax?
Retirement tax refers to the taxes retirees pay on income sources like pensions (including State Pension), dividends from shares, rental on property, interest on savings accounts, depending on their total income and applicable tax rules. Proper planning can help minimise these taxes to preserve retirement income.
Meanwhile, the State Pension has increased from £179.60 (2021/22) to £221.20 a week. In 2024/25, the full new State Pension amount is £11,502.40 a year – only £1,067.60 less than the Personal Allowance.
Of course we do not know what the level of inflation will be, however, if the new State Pension were to rise by 3.2% next year (the current rate of inflation), the full amount would increase to £11,870.48. As a result, if you’re in receipt of the full State Pension, you’re likely to have used a significant amount of your Personal Allowance.
You may be drawing from private or workplace pensions on top of your State Pension too, so you could easily exceed your Personal Allowance and pay a significant Income Tax bill.
According to FTAdviser, 1.2 million pensioners have already been pulled into paying Income Tax since April 2021 and an estimated 1.6 million more retirees will pay Income Tax by 2027/28.
If you’re affected by tax creep, you might find it more difficult to draw sustainably from your pensions. Fortunately, there are ways to potentially mitigate the effects of tax creep in retirement.
Strategies to Manage Tax Creep in Retirement
1. Consider what level of income you draw from your pensions
It may be useful to consider what level of income you draw from your pensions and whether it’s suitable for your lifestyle. If you take more than you’re likely to spend, a larger portion of your income could exceed the Personal Allowance each year, meaning you pay more Income Tax.
But, if you can reduce the amount you draw from your pensions each financial year, without affecting your lifestyle, you may be able to limit the income that exceeds your Personal Allowance. Depending on your spending habits, you might not reach the threshold at all.
Creating a detailed retirement budget can help you determine what level of income you need to fund your desired lifestyle in retirement. You can then draw this specific amount and potentially avoid taking taxable income that you don’t need.
2. Use your tax-free lump sum carefully
Normally, the first 25% you draw from a defined contribution (DC) pension (up to a maximum of £268,275) is tax-free. You can take this in one single lump sum or as several smaller amounts.
You might decide to take one lump sum for a specific purpose. For example, you may want to buy a holiday home or a new car. However, if you don’t need the full amount all at once, it may be beneficial to take it as several smaller amounts.
This could allow you to spread the tax-free 25% over several financial years, meaning you can reduce the Income Tax you pay. You might want to consider your retirement budget and only use the portion of your tax-free lump sum that you need. It’s essential to plan carefully, as withdrawing too much too soon could lead to unexpected tax implications. Additionally, if you invest your lump sum without a clear strategy, you may face the risk of paying tax on interest earned on those investments, diminishing your overall returns. A well-thought-out approach can help you maximize your tax benefits while securing your financial future.
Tip: Use lump sums for specific large purchases (e.g., holidays or major repairs) while keeping smaller withdrawals for regular expenses.
3. Use other savings before accessing your pensions
You may generate much of your retirement income from your pensions, but you might have other savings too. Accessing these funds before you draw from your pensions could also help you reduce the tax you pay.
There is no Income Tax to pay on funds in an ISA and you don’t attract Dividend Tax or Capital Gains Tax (CGT) on investments in a Stocks and Shares ISA. Consequently, if you use wealth in an ISA instead of your pensions to fund your lifestyle, you might pay less Income Tax.
You could use a combination of both, by drawing from your pension up to your Personal Allowance and then supplementing your income with ISA savings. This allows you to stay within your Personal Allowance, potentially meaning you don’t pay any Income Tax.
Tip: Combining pension withdrawals and ISA funds may enable you to maintain a comfortable lifestyle without breaching tax thresholds.
4. Defer your State Pension
In 2024/25, you can start claiming your State Pension from age 66, but you don’t have to. If you decide you don’t need the extra payments, you can defer them. Considering the State Pension is close to using almost all your Personal Allowance, deferring could make it easier to reduce the Income Tax you pay.
Early in your retirement, you could rely on an income from more tax-efficient sources such as ISAs, as well as your private and workplace pensions. Then, you might claim your State Pension later in life, once you’ve depleted other resources.
The other potential benefit of deferring is that your payments will be higher when you eventually do claim your State Pension. That’s because State Pension payments increase by 5.8% for every year that you defer.
So, after one year, your weekly payment would increase from £221.20 to £234.02. This may be a relatively small difference but if you defer for several years, your payments could increase significantly.
Example: Deferring your state pension for three years could raise your weekly pension payments to approximately £248.60, providing a more robust income later in retirement.
Frequently Asked Questions About Tax Creep
Who is most affected by tax creep?
Retirees, due to rising State Pensions and fixed income tax thresholds, are among the most impacted groups.
How can tax creep affect my retirement?
It can reduce the net income available from your pensions and other savings, increasing your overall tax liability.
What steps can I take to minimise tax creep?
Strategies include optimising pension withdrawals, deferring your State Pension, and using tax-free savings like ISAs for income.
Will tax thresholds remain frozen?
The UK government has frozen thresholds until at least 2028, but future changes depend on economic and political decisions.
Expert Tax Planning Tips for Retirees
If you’re worried about tax creep and its effects on your retirement plans, our expert financial advisors can help:
- Assess your income sources and identify tax-saving opportunities.
- Develop tailored strategies to minimise your tax liabilities while preserving your lifestyle.
- Guide you through complex tax rules to make the most of your pension and savings.
Get in touch
If you are concerned about tax creep in retirement, we can help you explore ways to mitigate a large tax bill.
Email hello@fcadvice.co.uk or call 0333 241 9900 for more information.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
Workplace pensions are regulated by The Pension Regulator.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.
