Pension tax allowance for low-income pensioners: Here’s how it works

The chancellor has been strong-armed into a change on the state pension. The triple lock has done its job so well that it is set to burst through the deep-frozen personal allowance – and something had to give.

Healey may have ‘solved’ the problem – not taxing low-earning pensioners – but this is far from an elegant fix.

Tapering the new Pension Tax Allowance gets around the potential unfairness of removing the allowance completely once income exceeded the state pension and means those with only a modest private pension will pay just a small amount of tax on those savings. But it still means those who have done the right thing and saved could rightly argue their diligence has effectively been punished.

Those still in work have every reason to feel aggrieved too. They could be living on exactly the same £13,037 income, yet still pay £94 in tax – with national insurance contributions added on top.

That tax gap will get wider too, with low-income workers seeing the frozen personal allowance bite while low-income pensioners are shielded.

How does the pension tax allowance work in practice?

The Pension Tax Allowance is a new tax-free allowance only available to those who have reached the state pension age (currently just over 67 rising to 68 by March 2028).

It will sit above the personal allowance, extending the amount of income these pensioners can receive and not pay any tax.

It will be set at an initial level of £13,037 and will increase at the same rate as the state pension in the 2028-29 and 2029-30 tax years.

It applies regardless of the source of pensioners’ income. Income includes state pension, private pension, earnings, self-employed earnings, savings, property or dividend income, or a combination of all these.

To avoid a cliff edge, the pension tax allowance will gradually reduce as a pensioner’s income increases. For every £3 of income above the full level of the new State Pension, the pension tax allowance will reduce by £1, so:

• If total income is below the personal allowance of £12,570, the pensioner has no liability for tax
• If total income is between £12,570 and £13,037, the pensioner receives the full Pension Tax Allowance (up to £94)
• If total income is between £13,037 and £13,319, they receive some Pension Tax Allowance
• If total income is £13,319 or more, they will not receive any Pension Tax Allowance

Examples of how this could work

Alison receives only the full new state pension of £13,037, and no other income. She will pay no tax.

Bill receives a new state pension of £13,000, as well as £37 annuity. He will not pay any tax.

Claire receives a basic state pension of £9,989 and a workplace pension income of £3,335, a total of £13,324. She will have to pay tax on £754 - her income above the personal allowance.

David receives a new state pension of £12,900 and a private pension income of £242 a year, giving a total income of £13,142, £105 above £13,037. David’s Pension Tax Allowance is reduced by £1 for every £3 income over £13,037, lowering it to £432 (£467 less £35). His total tax-free allowance will therefore be £13,002 (£12,570 plus £432), and he will have to pay tax on £140 of income (£13,142 less £13,002).

Evie is a 21-year-old student. She earns £13,030 a year. She will have to pay tax on £460 – her income above the personal allowance.

Diluting the triple lock guarantee

From April 2030, the triple lock guarantee for increases to state pensions will be diluted so increases to state pensions are based on the higher of 2.5% and inflation, with a check against a smoothed increase in average earnings.

Smoothing earnings increases may save the Treasury billions, but it also means pensioners could miss out when wages rise sharply. The £50 billion saving comes at a cost: less generous state pension increases and greater uncertainty for people trying to plan for retirement. The Government must be honest about what this change means for pensioners’ incomes over the long term.