Beware the pension tax

Reaching 66 can mean your work pension shrinks, warns Paul Lewis

Portrait of a Senior Businesswoman

Steve emailed me to say he was being robbed – and by Her Majesty’s Revenue and Customs, no less! He receives a pension from his old employer, and he was happily paying the tax on it.  His tax-free allowance is the standard £12,570, and Steve had been paying tax on the rest of his £17,000 pension – which came to £886 a year (or £73.83 a month), which was automatically deducted by his pension provider.

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But then Steve reached 66 and claimed his state pension, which was £7,000 a year. When he got his next monthly works pension he was shocked to see the tax taken from it had gone up. In fact it had almost trebled! And when he looked at the accompanying statement, he saw that this was because his tax-free allowance had been reduced from £12,570 to £5,570 – hence his plea, “I’m being robbed!”

This feeling is common when people first claim their state pension. In fact, Steve was paying the correct tax. The state pension is paid gross – without tax being deducted – but it is taxable. In other words, if your income is over the personal tax-free allowance, as Steve’s was, then you must pay tax on it.

The basic rate tax due on Steve’s £7,000- a-year state pension was £1,400. That tax is collected by taking more from your other taxable income, such as a pension or wages paid through the system known as PAYE.  Hence the extra £117 tax taken off Steve’s works pension each month. Instead of paying £886 per year tax, he was now paying £2,286 because that collects the £886 tax due on his works pension and the
£1,400 due on his state pension.

Like most people, Steve didn’t reach pension age on 6 April. So his state pension wasn’t paid for the whole tax year.  HMRC takes this into account and the £7,000 figure was just the state pension he would get in this tax year. In subsequent years the tax will go up again as HMRC taxes a whole 52 weeks of pension.

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Paul Lewis presents Money Box on Radio 4.