Tax Trap from State Pension Increase – What Can You Do?

The state pension, which millions of retirees rely on, might see a generous increase next year due to the recent 8.5% boost in average annual earnings between May and July. For those unaware, the state pension rise is linked to the “triple lock” system. In simple terms, this ensures the pension increases each year based on the highest of three figures: average earnings growth, inflation, or 2.5%. Given our recent earnings boost, this would mean a corresponding rise in the state pension. Even if the government chooses to use another calculation excluding bonuses, which stands at 7.8%, it’s still a win as this rate remains ahead of current inflation levels.

However, there’s a catch. With an increased state pension, more of your £12,570 tax-free personal allowance will be used up. Just to give you an idea, an 8.5% increase in the state pension would raise its total value from £10,600 this tax year to over £11,500 in 2024-25. And remember, once you go beyond this tax-free personal allowance, a 20% tax is applied. Considering the personal allowance remains fixed until at least April 2028, it’s evident that this allowance might soon be entirely used up by the state pension.

Diversifying Your Retirement Income

This is where the importance of diverse retirement income comes into play. Investor’s Chronicle breaks it down:

  1. Private Pensions: You can take 25% of what you’ve accumulated in private pensions without any tax. However, the remaining 75% is taxable.
  2. Investment Dividends: You’re allowed to earn up to £1,000 tax-free from investments outside of individual savings accounts (Isas) and pensions this tax year. However, this figure will be reduced to £500 from April 2024.
  3. Capital Gains: This year, you can sell investments outside of Isas and pensions with gains up to £6,000 before being taxed. This allowance will halve to £3,000 from next year. Don’t forget that you can also offset any losses against these gains.

It’s smart to have a mixture of growth and income investments. This way, you can use both the dividend and capital gains tax (CGT) allowances before taking money from Isas, especially since these allowances can’t be carried over to the next year.

Regularly cashing in gains from investments that aren’t wrapped in tax protection also prevents their value from ballooning too much, saving you from potentially hefty future tax bills.

Making the Most of Your Savings and Allowances

When we talk about income from bond investments and cash held outside of pensions and Isas, you can use these against a personal savings allowance: £1,000 for basic-rate taxpayers and £500 for those in the higher bracket. If your annual taxable income stays within the £12,570 personal allowance, there’s an additional perk. You get a special starting rate for savings of £5,000. This adjusts slightly if you earn between £12,570 and £17,570.

For those tied in matrimony or a civil partnership, here’s a golden tip: use both sets of all your allowances. This strategy allows couples to maximise their tax-free income each year. Moreover, passing assets between partners doesn’t incur CGT. This means, with careful planning, you both could enjoy tax-free incomes of over £25,000 this tax year or over £22,000 in 2024-25.

Other Options to Consider

Isas: You can always turn to Isas for tax-free withdrawals. An advantage with Isas, in contrast to pensions, is that there’s no age limit to when you can access your savings. Plus, you can stash away up to £20,000 a year in them.

Venture Capital Trusts (VCTs): A more adventurous option, VCTs grant you 30% income tax relief if you hold onto them for a minimum of five years. Additionally, they offer tax-free dividends. But, proceed with caution; they primarily invest in new, unproven companies, which inherently come with a high-risk tag. Explore VCTs only after you’ve exhausted all other avenues and if you have a significant taxable income.

Conclusion

The changing financial landscape can seem like a maze, especially when it affects something as crucial as retirement income. By understanding these changes, planning wisely, and diversifying your sources of income, you can enjoy your retirement years with financial peace and security.