What a 3.9% state pension hike could mean for your tax bill

Based on the earnings figures for July, the odds are that pensioners will be receiving just shy of £500 extra in their state pension next year.

Although we still need to see September’s inflation figure and any revisions to July’s earnings growth before we know definitively how much it will increase by in 2027, it’s looking very likely that the value of the full new state pension will surge past £13,000 – and the personal allowance – for the first time.

Even using the lowest measure of 2.5% under the triple lock means the full state pension amount would exceed the personal allowance of £12,570. The government has said people in receipt of state pension income only above the personal allowance will not have to pay income tax on the benefit, although details on exactly how this will work remain thin on the ground.

Up to now, politicians of all stripes have pledged allegiance to the triple lock. But as Chancellor John Healey drafts Budget plans on how the UK can face up to its fiscal challenges, it could be that cracks in this cast-iron support may start to show. The longer this unexploded fiscal bomb is left untouched, the harder it will be to diffuse – and the greater the chance proposed state pension age increases will need to be accelerated to balance the books.

A sensible approach would be to set a target for the triple lock policy, most likely a value of the state pension as a proportion of median earnings, and then a pledge to peg state pension increases to earnings growth or inflation. Any party that wanted to oppose such an approach would need to present a credible alternative. Keeping the triple lock forever certainly doesn’t fit with the government’s desire for long-term fiscal responsibility.

What would an increase of 3.9% mean?

Under the triple lock guarantee, the state pension increases by the highest of the rise in prices for September, average earnings growth for the three-month period ending in July, or 2.5%.

It’s expected the Consumer Prices Index (CPI) inflation rate up to September, which is due to be announced in mid-October, is unlikely to exceed the Bank of England’s predicted maximum of 3.2% for inflation in 2026. If these recent earnings figures form the basis for a 3.9% increase, the state pension would be worth around £13,036 a year, well in excess of the frozen personal allowance.

If the state pension then increased in line with the lowest rate possible under the triple lock of 2.5% until April 2031, it would then be worth almost £1,500 more than the personal allowance, meaning many more pensioners will be taxed on their income.

Uncertainty over state pension income taxation

Last year during her Budget speech, former chancellor Rachel Reeves confirmed that once the state pension clears the frozen personal allowance, pensioners whose sole income is the state pension will not be faced with the administrative hassle of simple assessment tax returns.

Collecting the little bits of tax owed from millions of pensioners was always going to be an administrative headache for the government. So it’s no wonder they’ve put their tax-collecting thinking caps on to find ways to avoid it.

How this policy will work and how any tax will be collected remains to be seen. The government stated that this will apply to people whose sole income is the state pension, but it wasn’t clear what else would be counted as income, let alone whether it would include income within tax allowances, tax-free income or state pension increments, such as deferred state pension income or the State Earnings Related Pension Scheme (SERPS).

We are yet to see any more details, and under the new Burnham administration this policy remains mired in uncertainty. Pensioners within this group are naturally starting to ask questions, but time will tell how the proposals shape up and whether they’ll actually make pensioners’ lives simpler.