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  • Writer's pictureInchmead

Warning on tax liability as state pension rises

HMRC is writing to taxpayers who will incur a tax liability on their state pensions removing them from self assessment, but are providing no indication of how the tax will be collected, says Sara Bonavia, associate director at RSM

HMRC is causing confusion by removing taxpayers from self-assessment, raising the question of whether state pensions should be taxed at source.

We have seen a number of letters in recent weeks where HMRC has written to taxpayers to remove them from self assessment when there is no other mechanism to collect the tax. This is causing confusion and worry for individuals and can also stack up issues for the future. Should HMRC be collecting tax on state pensions at source as a way to mitigate this?

Take individual A – they deferred their state pension so benefit from a significantly increased pension of around £20,000. They also have savings income of £1,500. Their income is clearly over the personal allowance and savings allowance, and therefore generates a tax liability.

There is no PAYE income, so no ability for HMRC to collect tax at source. The individual has been submitting tax returns and making payments on account each January and July for many years. However, they have now received a letter saying they no longer need to complete returns, with no indication as to how to pay their tax liability once their balancing payment for 2022/23 has been paid.

Individual B receives a UK state pension and an overseas private pension – and again, incurs a tax liability that has been collected via self assessment for many years. They have also been removed from self assessment with no indication of how to pay the tax.

Running the HMRC checker as to whether the individual needs a return comes back with ‘you need to send in a self assessment return’, which is not surprising given the resulting liability.

These individuals have approached RSM for advice as to what to do – one of them tried calling HMRC but gave up after 45 minutes, and both were worried that if they don’t continue to pay their tax they are storing up problems for the future.

This leads us to consider other options.

Individual A’s income could be fully taxed at source if the state pension was taxed under PAYE, and depending on the numbers, this could also be possible for individual B.

Increasing the state pension annually in a time of rising interest rates and falling dividend allowances, without increasing the personal allowance will gradually be dragging more and more pensioners into the position where they have a tax liability, but no clear mechanism to settle this efficiently.

The easy option would be to increase the personal allowance at the same rate as state pensions, but the government has already committed to freezing this until 5 April 2028, when it will start being indexed by the consumer price index.

State pensions are expected to rise by 8.5% in April 2024, taking the new state pension to £11,501 for 2024/25, leaving just £1,069 of personal allowance remaining.

A similar rate of increase in the following years would make the new state pension greater than the personal allowance well before 5 April 2028.

We call on HMRC and the government to keep simplicity for pensioners’ tax affairs and avoid them from building up unexpected tax liabilities.


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