The chancellor has promised a tax break for those who rely on the state pension, in a move that critics warn will create a two-tier retirement regime.

The full state pension will be liable for income tax when the triple lock pushes it above the personal tax-free allowance in 2027. But Rachel Reeves has said that HM Revenue & Customs (HMRC) will not tax those who rely solely on the state pension.

The former pensions minister Steve Webb has warned that this will create a two-tier system that will penalise those who set aside money for retirement and will bring “all sorts of unwelcome side-effects”. Experts have also warned that the chancellor’s plan would mean the state pension was effectively means-tested because those with retirement savings would receive less of it.

From April the new full state pension will increase to £12,548, taking it to £22 shy of the income tax threshold of £12,570. Given that the triple lock guarantees that the state pension will increase by 2.5 per cent (unless earnings growth or inflation is higher), it is guaranteed to increase to at least £12,862 by April 2027. This puts it £292 above the income tax threshold and could mean some pensioners need to hand back £58 in tax if they are a basic-rate taxpayer or £117 if they pay the higher rate.

There are 13.1 million people collecting a state pension, according to the Department for Work & Pensions, and figures from HMRC show that 8.72 million already pay income tax. And it may not be as simple as exempting some pensioners from paying any tax. Here, Times Money takes a look at the flaws of the retirement tax raid.

Older pensioners pay more

Someone on the basic state pension who reached retirement age before April 2016 will see their payments increase to £9,615 from April. But many already receive an income over the personal allowance — 2.5 million in fact, according to figures from the consultancy LCP. And there are no allowances for them to get out of income tax.

This is because while someone on the basic pension receives £176.45 a week, they can also claim another payment (the additional state pension), which is £222.10 a week. This could give them an overall income of £20,724 a year, which is more than £8,000 above the threshold. If they received the maximum amount they would have a tax bill of £1,631 a year, although it is worth noting that in this instance they received more income in the first place than someone who retired under the newer system.

But it does mean changes to the system could be seen as unfairly benefiting newer retirees, said the wealth manager and financial planner Carl Mba, because while someone receiving only the new state pension would pay no tax, someone receiving basic state pension plus the additional state pension, or a small private pension, would.

“It seems fundamentally unfair that two people living on very similar incomes can be treated so differently,” he said. “Income is income, people are people, and the cost of living is the cost of living, regardless of where your £1 comes from.”

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Punishing prudence

The government has said the exemption will apply to people with no income apart from their state pension, but this risks creating a “two-tier system” where those who set aside money for their retirement could be penalised.

“This new proposal creates all sorts of unwelcome side-effects,” Webb, now a partner at LCP, said. “In particular it seems very unfair to offer a ‘tax amnesty’ to people who have no private pension income but to take it away if people have even a tiny private pension.

“At a time when the government apparently wants more people to save for their retirement, punishing people for small amounts of pension saving sends the wrong signals entirely.”

The new rules will “create inequality and ultimately enable people to ‘game’ the system,” said Nick Nesbitt, the head of private client at Forvis Mazars accountancy firm. One of his clients, who has a £24,000 state pension after inheriting some of her husband’s entitlement, loses approximately 50 per cent of her £5,000 private pension because the tax due on her state pension is reclaimed from this private pot.

“Moving forward, if this were a drawdown arrangement she could choose not to draw her private pension income, perhaps instead rely on savings, and ultimately save 20 per cent income tax on the roughly £11,500 of that state pension that sits above the personal allowance. This deprives the government of around £2,300 per annum of tax take.”

These situations are rare, he said, but lower earners who have worked to save a modest private pot will “suffer more tax on their state pension than those who simply haven’t bothered to save for their own retirements”.

Unfair for workers

As well as creating a divide, there is a “broader fairness question here”, Lily Megson-Harvey from My Pension Expert said. A lower-income worker who earns just above the personal allowance threshold has to pay tax while someone who receives only the state pension does not.

“If two individuals have the same income, one from work and one from a mix of state and private pensions, they could face very different tax treatment,” she said. “While protecting vulnerable pensioners is vital, the system should also feel equitable across generations.”

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Modelling from the Intergenerational Foundation suggests the exemption could cost £143.8 million in 2030-31 and £256.7 million the year after. This policy would create an “absurd situation” where people receiving similar incomes could be paying different levels of tax depending on whether they are a pensioner or worker, according to Conor Nakkan, a senior researcher at the Intergenerational Foundation. He said: “At some point the government must recognise that this simply isn’t fair, especially when millions of younger workers will see their tax bills rise over the next few years.”

The £1 cliff edge

A cliff-edge approach to taxing state pension means someone who earns even £1 from a private pot could end up losing out on hundreds of pounds in tax.

Based on the assumption that the state pension increases by at least 2.5 per cent a year (and Reeves reaffirmed Labour’s commitment to the triple lock in her budget, so there is no sign the mechanism is going anywhere any time soon), it means every year more of the state pension will be above the threshold. So that £1 from a private income could cost £58 in year one, £122 in year two, £189 in year three and £256 by the final year of this parliament (2029).

This could lead pensioners to hold off touching their drawdown pot for as long as they can, Webb said. It may also mean some savers decide not to turn their small pension pot into a small annuity, since doing so could cost them hundreds of pounds in tax.

Deferring the state pension

Deferring your state pension could be a way to boost what you get — and it increases by 1 per cent for every nine weeks you defer. This works out at just under 5.8 per cent every year you don’t collect a payment. But those who defer do not get tax amnesty and in most cases anyone who has already deferred the state pension pays tax, so this is not changing.

Someone who claimed their pension this year would get £11,973. If they deferred they would get £12,667, an extra £694 a year. This means you need more than 17 years in retirement before you have made up for that missing year. But it does mean that if you live longer than that you have more than made up for the missing year. While someone who lived for 20 years in retirement would have lost out on an initial £11,973, they will have been paid an extra £13,880, which means they have made an extra £1,907. If Reeves’s policy ends after three years they would have missed out on £360 in tax savings, but those losses are likely to be dwarfed by their enhanced pension.

While it is unclear how long Reeves’s tax amnesty will last, it means someone who is deferring their pension before the end of parliament in 2029 could still be better off, Webb said. “If you live a long time, your long period on an enhanced pension more than makes up for a year without a pension, even allowing for the loss of the amnesty.”

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Is there a solution?

With relatively small sums involved, the “cleanest solution” would be for the government to “not bother to collect it”, Webb said. “This could apply equally to people on the new state pension and the old system, and to pensioners and workers alike. While this would not be perfect, it would be less unfair than arbitrarily favouring one specific group of pensioners over all others, which seems to be the current plan.”

Rachel Vahey from the investment firm AJ Bell said rather than making pensioners “go through the hassle of paying tiny amounts of tax, the government has chosen to simply let them off the hook”, but this “clumsy approach is just plain unfair”. “This policy is storing up problems for the future,” she added.

Megson-Harvey said many questions about the policy remain unanswered. “A clear plan is needed to support pension adequacy across all wealth brackets.”

A spokesperson for the Treasury confirmed: “As the chancellor has said, over this parliament those whose only income is the basic or new state pension, without any increments, will not have to pay income tax.”