Chancellor set to exempt poorest state pensioners from income tax in Budget

The Government could protect the poorest pensioners from income tax in the Budget on Wednesday. John Healey reportedly plans to raise their income tax threshold to £13,036, matching the full new state pension rate from next April.Those relying on just the state pension had been set to pay income tax on it for the first time, as the annual amount would breach the income tax threshold of £12,570. The new tax-free allowance for people who rely solely on the state pension is expected to rise in line with the headline annual payment for the rest of this parliament, meaning they won't pay tax until at least 2029. Full details are yet to be announced, but those who earn even £1 in private pension above their state pension look set to be excluded from the new tax rate.For these people, and everyone else, the threshold at which they start paying income tax will remain at £12,570. The scheme, which would cost £200million a year by 2030 according to a report in The Times, could create messy ‘cliff edges’ and be seen as unfair by those who did 'the right thing' and saved for old age, say pension industry experts. State pension: Government may protect people who rely solely on this from income taxThe headline state pension will rise by nearly £500 a year to £13,036 next April under the triple lock guarantee – the highest of inflation, earnings growth or 2.5 per cent.People who retired before spring 2016 on the old basic state pension will see a £7.20 a week rise to £192.10, or around £10,000 a year, still well below the income tax threshold.However, many on the basic rate also get hefty top-ups, called S2P or Serps, if those were earned earlier in life, and these often push them into paying income tax already. However, they might not be protected by the new Government tax allowance. The plan to lift people who live only on the state pension out of tax was announced by former chancellor Rachel Reeves last year, and her successor John Healey confirmed plans to go ahead with it.It is not clear yet if there will be further exemptions, such as for people who get extra state pension because they delayed taking their payments.Former Pensions Minster Steve Webb, now a partner at pension consultants LCP, says assuming minimum 2.5 per cent increases in the state pension, the amount of income tax waived would be £93.28 next year, £158.28 in 2028-29 and £224.84 in 2029-30. He says: 'This scheme is being developed because the repeated freezing of the personal allowance has dragged more and more pensioners into the tax net. 'But the proposed solution looks messy and increasingly expensive. The gap between the new state pension and the tax threshold is set to grow every year, which will make the policy hard to switch off. But if it continues, the cost will grow and grow.Webb, who is This is Money's pensions columnist, adds: 'If the extra allowance is available only to those on a low income, there could be a growing "cliff edge" problem where those with very small amounts of private income lose the whole allowance and end up worse off than those with nothing.'Kate Smith, head of pensions at Aegon, says: 'If these reports are confirmed, protecting those who rely solely on the state pension from paying income tax will be welcome news for some of the lowest-income pensioners.'However, there is a risk that creating a more generous tax position for those who have not built up additional retirement savings could be seen as unfair by people who have had the means to do the right thing and saved through workplace and private pensions.'Long-term pensions policy should be guided by fairness across generations and between different groups of savers, rather than short-term measures designed to fix one specific issue.'Any reforms need to support adequacy, reward saving and command confidence across the whole retirement system.'Tom Selby, director of public policy at AJ Bell, says: 'Reports of a 3.9 per cent state pension increase in line with wages will be a vital boost for pensioners worried about rising costs in 2027, but pushing it over the frozen personal allowance was always going to raise difficult questions.'It has been reported that government intends to tackle the problem with a personal allowance to match the state pension for low-income pensioners – which will then rise in sync with the state pension for a period.'While details remain thin on the ground, there is a danger in attempting to fulfil his predecessor Rachel Reeves’ promise not to apply income tax to those who only receive state pension income, Healey creates a mess of complexity, odd incentives and obvious unfairness in the tax system.'Selby says if those on state pension only benefit, pensioners who have saved could understandably argue their diligent behaviour has effectively been punished.However, a higher personal allowance for all pensioners would create a two-tier income tax system explicitly favouring older people, he points out.'Given those already above state pension age do not pay National Insurance currently, creating a further income tax benefit for older people risks hardening perceptions of intergenerational unfairnessPatrick Thomson, head of policy at Standard Life Centre for the Future of Retirement, says the new tax protection could be worth £770 if it lasts as long as the personal allowance freeze, which is set to continue until spring 2031.However, the saving would be higher if the state pension increases by more than the mininum 2.5 per cent.'This will be a relief for those affected, avoiding both an unexpected tax bill and additional tax administration,' he says.'Much will depend on the detail of the protection and who qualifies. If it applies only to those whose sole income is the state pension, people with even relatively modest workplace or private pension income could still be affected.'What looks like a relatively simple solution could become more complicated over time as the state pension continues to rise against a frozen personal allowance, widening the difference in tax treatment between those relying on the state pension alone and those with relatively small amounts of additional retirement income.'SIPPS: INVEST TO BUILD YOUR PENSIONAJ BellAJ Bell0.25% account fee. Full range of investmentsHargreaves LansdownHargreaves LansdownFree fund dealing, 40% off account feesInteractive InvestorInteractive InvestorFrom £5.99 per month, £100 of free tradesInvestEngineInvestEngineFee-free ETF investing, £100 welcome bonusProsperProsperNo account fee and 30 ETF fees refundedAffiliate links: If you take out a product This is Money may earn a commission. 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