What is “tax creep” and how can you manage it 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 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.

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.

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.

Four ways to potentially reduce the Income Tax you pay 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.

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.

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.

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.

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