How pensioners can beat the stealth tax raid

• The annual full state pension of £11,502.40 is closing in on the £12,570 tax-free personal allowance
• New research shows 1.6 million more pensioners are set to pay income tax by 2027/28*
• 8.5 million pensionersare expected to pay income tax in 2023/24, with 1.2 million already added since the tax band freeze began
• Planning how and where you take your income as well as maximising tax-free allowances can help pensioners beat the stealth tax raid

*Based on House of Commons Library analysis commissioned by the Liberal Democrats.

Charlene Young, pensions and savings expert at AJ Bell, comments:

"Soaring inflation and wages mean that the triple-locked state pension increased by another 8.5% this month, taking the full flat-rate state pension to just over £11,500 a year. However, with the Personal Allowance still frozen at £12,570, the state pension will take up the lion's share of that tax-free allowance.

"We've seen this play out in government figures that show in since April 2021, over 1.2 million more pensioners have already been dragged into the income tax net. This isn't the end of the story, as allowances continue to be frozen, or even cut in the case of dividends. New analysis by House of Commons Library commissioned by the Liberal Democrats estimates that another 1.2 million pensioners will be pulled into paying income tax in the 2024/25 tax year, rising to 1.6 million more by 2027/28, compared to if no freeze had been in place.

"If you're one of those dragged into the tax net, with some smart planning you can make sure you're keeping as much of your extra income as possible, rather than giving it to the taxman."

Use ISAs for tax-free income

The annual ISA allowance is £20,000 per tax year (per person). From 6 April, you can spread it across multiple ISAs of the same type.

As any income generated by your ISA cash and investments is sheltered from income tax, they should be your first port of call for tax-free income. You can also withdraw money from ISAs anytime tax free if you wanted to supplement your other income without paying any tax.

Maximise you pension tax-free cash

When you come to access your pension(s), up to 25% can usually be taken as tax-free cash. You might have plans for the cash, including using it to top up your income tax free. But many people don't realise you don't actually have to take it all in one go.

What you don't take out can be left invested in your pension where it can continue to grow tax free, and then used to give you chunks of tax-free cash when you need it.

If you've got a bit of your Personal Allowance left, a neat trick is to withdraw money from your pension to take you up to the Personal Allowance limit. For example, if you have £1,000 personal allowance left after your full state pension, you could tell your provider you want to access £1,300 in total as a blend of tax-free cash and income. The first 25% (£325) will be tax-free, and the remaining £975 still falls within your tax-free personal allowance.

Still working? Pension contributions can help lower your tax rate

You can still pay into your pension even if you've already accessed it, and it might lower the income tax you pay. You'll likely have a lower limit on what you can pay into your pension each year if you've already taken income from a private pension. This annual allowance (known as the Money Purchase Annual Allowance) will usually be £10,000 a year, but provided you don't go over that and you're under 75, paying into your pension could move you into a lower tax bracket as it reduces your taxable income.

The same concept applies to charity donations using Gift Aid. The charity gets a 25% boost on what you donate, and the total value of your donation (including the Gift Aid boost) is deducted from your total taxable income.

Know your allowances

You can also boost your tax-free income by making sure you use up all the tax breaks you're entitled to.

• Starting rate for savings

If you've got total taxable income of under £17,570 a year, there's a special 0% rate of income tax for savings income up to £5,000 a year. It's called the 'starting rate' for savings. The income measured against it includes pension income, like the state pension.

If your income is less than the personal allowance, you'll be able to get up to £5,000 interest completely free of tax. If your income is over £12,570 but below £17,570, then you'll lose £1 of the starting rate for every £1 of income above £12,570, until it fully disappears at £17,570.

• Personal savings allowance

You'll pay tax on any interest you earn on cash savings that exceeds your personal savings allowance, which currently stands at £1,000 for basic-rate taxpayers and £500 for higher-rate taxpayers. Additional rate taxpayers have no personal savings allowance.

If you're getting 5% interest you'll hit the allowance when you have a cash pot of £20,000 for a basic-rate taxpayer, or £10,000 for higher-rate taxpayers.

• Dividends

The tax-free dividend allowance will be cut again on 6 April to just £500 a year. If your non-ISA investment pot is larger than your ISA allowance or you're worried about gains, you might want to prioritise shifting your biggest dividend-paying investments into your ISA first. This means that you can shelter more of your dividend income from tax first and therefore cut your tax bill.

• Capital gains

The capital gains tax-free allowance is £3,000 from 6 April, less than a quarter of what it was two years ago. Although this is for investment gains, the rate of capital gains tax you'll pay on gains above the allowance depends on your income.

For those sitting on gains you can sell assets to realise a gain up to your remaining tax-free allowance and then buy it back within your ISA, which means you'll make use of the tax-free allowance, potentially boost your ISA tax-free income and protect any future gains from the taxman. Ask your investment platform about their 'Bed and ISA' service.

In a couple?

Organising your finances between you can make the allowances go even further and potentially save you more tax. There's also a special allowance on offer for some married couples.

1. If you've got a decent cash savings pile, it might be advantageous to split it between a couple. If your partner has an unused personal savings allowance then cash could be held in their name instead. Or, if one you is a lower-rate taxpayer, it might make sense for them to have the bulk of the non-ISA savings so you pay a lower tax rate on the savings interest.
2. For investments and the dividend tax, you could also look at splitting the non-ISA investment pot between you, assuming you've already made the most of your ISA allowances.
3. Transfers between spouses and civil partners are not subject to capital gains tax. This can be helpful if you've got investments with gains that you're looking to sell or transfer to an ISA but you're already at or near your own CGT allowance. The original 'book cost' also transfers across with the investment, so make sure you keep a note of what was paid as it'll be used when your partner comes to sell.

Claim marriage allowance

If you're married or in a civil partnership and one of you is a non-taxpayer, the marriage allowance lets them transfer 10% of their personal allowance to their partner and could save you up to £252 a year in tax.

To claim, the person receiving the extra personal allowance must be a basic-rate (20%) taxpayer* at most. A little-known tip is that you can also backdate your claim for up to four tax years, if eligible. An alternative option, called the married couple's allowance, is available for people born before 6 April 1935.

*In Scotland, the recipient can be a starter, basic or intermediate rate taxpayer.

How you'll pay any tax due

It's also useful to know how your income is taxed if you go over your allowances. Although the state pension is paid gross (with no tax deduction), it's added to your other income from pensions, savings and investments for tax purposes.

Pension income will be paid by your pension provider with any income tax due already deducted. Like an employer, they'll send you a payslip with the details including the tax code they've been given by HMRC. Keep in mind that they may also have deducted any tax due on your state pension.

Your bank or building society pays savings interest without deducting any tax. They'll also tell HMRC how much they've paid you, who'll then calculate any tax due. If you don't usually file a self-assessment tax return, tax will usually be collected via a change to your tax code. This could mean you see the tax deducted on your pension payslip each month, before you've realised that you owe anything.

If you received more than £10,000 from savings and investments, it's likely you'll have to register for and complete a self-assessment tax return if you don't already.