Savers are being urged to prepare for a double tax attack on pensions in less than 18 months’ time.
Official data published on Tuesday means that the new state pension will rise 4.7 per cent in April, thanks to the triple lock guarantee. It means that, unless the guarantee is abandoned, a full state pension will be worth more than the annual tax-free income allowance from 2027 — so most pensioners will have to pay tax.
On the same date, new rules will come into force bringing pensions inside your estate for inheritance tax purposes. Any savings left in your pot when you die could be taxed at 40 per cent.
The two-pronged tax raid means that savers face higher taxes on money withdrawn from their pensions and higher taxes on any money left untouched. As more and more pensioners face a growing tax burden in old age, The Sunday Times has found:
• A private pension of less than £1 a week will trigger a tax bill for those on the state pension from April
• The taxman will claw back more than £1 billion of the triple lock pension increase in extra income tax
• Fears over higher tax bills have driven pensioners to pull an extra £18.7 billion from their pots
• Financial advisers are telling clients to take steps to prepare for the tax raid
“The inheritance tax change coming in April 2027 represents one of the most significant shifts in retirement and estate planning in decades. The advantage of passing on wealth through pensions is disappearing,” said Roddy Munro from the advice firm Quilter.
“At the same time, if you get the full state pension, every pound drawn from a private pension on top of that will be taxed at a minimum of 20 per cent. This creates a difficult trade-off between paying income tax now or risking a larger inheritance tax bill later.”
The triple lock hot potato
The triple lock guarantee, which came into force in 2011, means that the state pension rises each year with inflation, earnings growth, or 2.5 per cent — whichever is highest.
The promise has caused a headache for those in power. According to the Office for Budget Responsibility (OBR), the annual cost of the triple lock is estimated to reach £15.5 billion by 2030, three times the original estimate, but politicians have repeatedly pledged to keep the lock in place for fear of alienating pensioners at the ballot box.
Torsten Bell, the pensions minister, has previously described the formula as a “messy tool” but last week committed to keeping the lock. Sir Mel Stride, the shadow chancellor, has previously branded it unsustainable but on Tuesday said that the Conservative Party “stood by” it. Reform UK has refused to take a position.
Earnings data published this week showed that earnings increased 4.7 per cent in the three months to July. This is likely to beat the inflation figure for the year to September, which will be released next month and so in April 2026 the new full state pension will rise from £11,973 to about £12,535 a year.
According to Steve Webb, a former pensions minister who is now partner at the pensions consultants LCP, the jump will cost the Treasury about £6.68 billion.
Giving with one hand …
Rishi Sunak introduced the freeze in 2021 and Jeremy Hunt extended it until 2028
PAUL ELLIS/PA WIRE
Pensioners will not feel the full effect of this boost in their pockets. HM Revenue & Customs data shows that about 88 per cent of taxpaying pensioners pay the basic rate of 20 per cent, 10 per cent pay the higher rate of 40 per cent and 2 per cent pay the additional rate of 45 per cent. This gives pensioners a weighted average tax rate of 22.5 per cent.
According to Webb, about three quarters of pensioners pay tax. This means that about £5 billion of the extra £6.68 billion state pension is taxed at a rate of 22.5 per cent, so the government is set to claw back about £1.1 billion in tax.
Pensioners’ tax bills are made worse by the policy of frozen tax thresholds. Income tax thresholds have been frozen since 2021 when Rishi Sunak, as chancellor, announced a five-year freeze. Jeremy Hunt extended the freeze until 2028, and it is feared that it will be extended further in the November budget.
Almost 9.2 million over-65s are expected to pay income tax in this tax year, up from 6.5 million a decade ago and three times as many as the 3.1 million who paid income tax in 1990. They make up 24 per cent of all income taxpayers, up from 21 per cent in 2015 and 12 per cent in the 1990s.
“The long-term freeze on tax-free allowances means that nearly three in four pensioners now pay income tax,” Webb said. “The result is that the government will claw back about £1 billion in extra tax revenue out of the pension rise next April.”
• Why a tax panic is sweeping through the middle class
The freeze means that the personal allowance, the amount of income you can get tax-free each year, has been stuck at £12,570 for four years. In April 2027, when the state pension will rise by a minimum of 2.5 per cent, it will surpass the threshold and all pensioners will have to pay back part of their state pension in income tax for the first time.
Once the state pension takes up a saver’s full personal allowance, every £1 they withdraw from a private pension will be taxed at least 20 per cent. Even from April 2026, when the state pension takes up nearly all of the personal allowance, any private pension paying more than £36 a year will result in an income tax bill for the pensioner.
How to cut your bill
Savers are already making moves to lower their potential future tax bills.
The Financial Conduct Authority, the City watchdog, said this week that £70.9 billion was withdrawn from pension pots being accessed for the first time in the 2024-25 tax year, up from £52.2 billion the year before and a jump of 36 per cent. Regular withdrawals from those in drawdown products — where you keep your money invested and withdraw an income as and when you need it — increased from £7.1 billion last year to £8.6 billion this year.
“Many people are looking to take more out of their pensions because of the forthcoming rule changes. We know this not just from conversations with clients, but also the official data from the FCA,” said Andrew King from the wealth manager Evelyn Partners.
The surge in activity has prompted those at the coalface to call for Rachel Reeves, the chancellor, to announce a “pensions tax lock” that would rule out changes to pensions tax for this parliament. That way, savers will not make hasty moves based on speculation over changes to the rules around tax-free cash or tax relief.
“A pensions tax lock would give the stability people desperately need to plan for retirement with confidence,” said Rachel Vahey from the investment platform AJ Bell.
The idea that taking money out of your pension could be the smart play — rather than leaving as much inside as possible — is a complete U-turn on traditional financial planning. The advice before last year’s budget was to spend everything else before the pension because your pot could be left to your beneficiaries free from inheritance tax.
Now, though, the balance is trickier. Alex Shields from the advice firm The Private Office said: “A lot of people’s plans were to just leave their pensions. Now the combination of inheritance tax and frozen tax thresholds means that people are going to want to take more income from their pensions, and they need to think about how and when they are going to do that.”
• More tax pain is coming — and it will hurt more than you think
If you want to take money from your pension tax-efficiently, Shields suggests thinking about withdrawing money before you reach the state pension age of 67 if you have already retired. This way, you can make the most of your tax-free allowance before the state pension kicks in.
He said: “If you take £16,760 as a lump sum each year until you hit state pension age, you can get 25 per cent of that tax-free as part of your tax-free cash. The remaining £12,570 is within the personal allowance, so it is quite a neat way to get income out of your pension tax-free.”
Why you should make gifts now
There are still generous gifting exemptions within the inheritance tax rules. Anything you give seven years before you die is tax-free, and you can give £3,000 a year without it being added to your estate.
One of the most lucrative options is to give a “regular gift out of surplus income”. The money has to come from income, rather than capital, and has to be above and beyond your regular expenses so it does not lower your standard of living. If you keep a clear record and the gifts meet these requirements, then they are inheritance tax-free.
If you don’t want to give up access to your funds just yet — or want to leave the money within your pension to ensure you can fund your lifestyle later in life — then it’s worth thinking about an insurance policy to cover your tax bill.
• How to avoid paying tax in retirement (legally)
You could opt for a joint whole-of-life policy, written into a trust. This would pay out on second death (either yours or your spouse’s) and the payout would sit outside your estate, so it would be tax-free. Your beneficiaries could use the proceeds to pay the tax bill.
All advisers recommended doing a thorough review of your financial plan, keeping documents such as wills and pension beneficiary forms updated and seeking expert advice before you make any big or irreversible changes.
“This is not a minor technical adjustment. It is a structural change that will affect how people plan for retirement and how they pass on wealth for years to come,” Munro said. “Those who act early and review their strategies will be best placed to protect both their own financial security and their family’s legacy.”