The state pension tax debate – issues arising from the budget 2025 announcement

Background – state pensions and tax

With the personal allowance now confirmed to be frozen at its current level of £12,570 until April 2031, and increases in the state pension guaranteed to be at least 2.5% annually under the triple lock, the value of the full new state pension is gradually catching up with the tax-free threshold. The full new state pension will exceed the personal allowance for the first time from April 2027 when it is set to be at least £12,861. As a result, some pensioners will have to pay income tax for the first time even if the state pension is their only income.

This is not a new situation. There are already around 2.6 million individuals who receive state pension at a level exceeding the personal allowance. This is because state pensioners on the old basic state pension can be eligible for extra entitlements, such as additional state pension, protected payments, pension inherited from a deceased spouse and increased state pension through state pension deferment.

How tax is collected on the state pension

Currently, if a person’s state pension means that their taxable income exceeds the personal allowance and they have no PAYE income (such as from employment or a personal pension) from which the tax can be deducted, HMRC use the simple assessment system to collect the tax due. While this is administratively easier for a taxpayer than having to complete a self assessment tax return, a simple assessment tax bill can be confusing or worrying for pensioners who are unfamiliar with the process. In addition, if the simple assessment is unexpected, they may not have budgeted for the tax due, which can mean they find the bill difficult to pay.

The government’s budget announcement

The announcement included in the 2025 budget documents stated:

“The government will ease the administrative burden for pensioners whose sole income is the basic or new State Pension without any increments so that they do not have to pay small amounts of tax via Simple Assessment from 2027-28 if the new or basic State Pension exceeds the Personal Allowance from that point.” (Paragraph 4.167 HC 1492 – Budget 2025 Strong Foundations, Secure Future – November 2025)

Measures that simplify administration are generally welcome, so the possibility of some pensioners not having to deal with simple assessment was encouraging. However, the announcement was unclear in terms of its scope.

Some commentators interpreted the announcement as purely administrative, aimed at reducing the administrative burden of budgeting for and paying tax in arrears via simple assessment but not changing the amount of tax due. This interpretation was supported in part by the fact that there were no operational details or costings in the budget documents. We initially thought that the government might be considering our suggestion of applying PAYE to the state pension. This would mean any tax due is deducted over the course of the tax year, reducing budgeting problems. It would also ensure more transparency about the fact that the state pension is taxable – something that is not well understood.

However, some commentators interpreted it as meaning those pensioners in scope would not have to pay the tax at all, so not purely administrative in nature.

The Chancellor’s comments since the budget

This second, wider interpretation has since been confirmed by the Chancellor in an interview – she confirmed that tax will not be payable on amounts in excess of the personal allowance, saying:

“I do recognise that if you are just in receipt of the basic state pension or the new state pension, it would not be the right thing to try to tax those small amounts of money”.

She also said that those whose only income is the full new state pension will not have to pay the “tiny amounts” of tax they will owe as a result of their pension exceeding the personal allowance in this parliament.

This clarification, meaning the measure goes beyond administration, set out by Rachel Reeves, appears to offer relief to pensioners facing modest tax bills. However, it raises a number of questions which are giving rise to speculation and uncertainty and some of which need urgent clarification.

Timing – clarification is urgently needed

There is confusion over the timing of the introduction of this measure. The budget document specifies that it will apply from 2027/28, but the Chancellor stated that state pensioners would not need to pay the tax in question “in this parliament”. We have already seen questions regarding the validity of simple assessment tax demands issued by HMRC in relation to tax year 2024/25.

The government should seek to clarify this aspect of the policy as a priority to give certainty to those affected and quash any unhelpful speculation. Otherwise, there is a danger that some people will inadvertently fall into non-compliance, mistakenly believing that they do not need to pay their simple assessment tax bill for 2024/25.

Limited clarity on the practicalities

The operational detail for this measure is not yet available – the budget announcement promises that more detail will follow next year. This measure was initially presented as an administrative simplification but will continue to create uncertainty until clarification is published.

We would encourage the government to consult on the proposed policy and consider the following to be the key points that need to be considered:

Legal basis

Will the government legislate to make the state pension tax-free for certain pensioners? A formal legislative exemption would provide certainty but could have long-term consequences for tax policy. Another option would be to legislate to make the state pension exempt from tax up to a certain amount, for example, the amount of the full new state pension. However, that would benefit all state pensioners, not only those reliant solely on the state pension as intended. Alternatively, will HMRC simply be instructed not to collect tax up to a certain amount? An informal administrative approach could be reversed or modified more easily, but this would create uncertainty for future pensioners.

Qualifying criteria

Clear parameters will be required to understand the scope of the policy, in particular:

What type of state pension will qualify?

The budget announcement refers to those whose only income is “the basic or new state pension without any increments”. But further to the Chancellor’s comments since the budget, clarification over the eligibility for this exemption for those in receipt of enhanced state pension entitlements is required. Some pensioners receiving the additional state pension may already have income well in excess of the personal allowance. If they were to benefit from the proposed exemption this could result in significant tax bills being waived.

How will “other income” be defined?

It will be important to understand what is meant by other income and how it will interact with existing tax allowances. For example:   

• Savings and dividend income - income which falls within a person’s savings and dividend allowances is taxed at 0% therefore no tax charge arises.
• Other tax-free income - tax allowances exist for income from letting a room in your home (known as rent-a-room relief), property and miscellaneous trading activities, meaning that, up to specified amounts depending on the income type, no tax charge arises and the income does not need to be reported to HMRC.

Will income within these allowances on which no tax charge arises be classed as “other income” for the purposes of qualifying for the exemption?

It is also not clear how this policy will interact with marriage allowance claims.

Administration

There are many practical considerations that need to be addressed, for example:

• How will HMRC identify those who meet the ‘state pension only’ criteria for this exemption without the need to obtain declarations from the pensioners concerned? Requesting such evidence would simply replace simple assessment with another administrative task and add to existing pressures within HMRC.
• If the policy only applies from 2027/28 onwards, then HMRC will need to take steps to raise awareness of the fact that simple assessment bills in respect of state pensions for tax years up to and including 2026/27 must still be paid.

No Transparency on the cost

The budget documents do not set out the expected cost to the Exchequer of foregoing these future tax receipts. The absence of costing raises several questions:

• How many pensioners are expected to benefit each year from the measure?
• What is the projected tax loss as the state pension continues to rise while the personal allowance remains frozen?
• Has the Treasury allocated funding for this measure in future years, or is the cost expected to be absorbed through efficiencies or higher effective taxation elsewhere?

Without this information it is difficult to assess the longer term sustainability of the measure.

As a point of reference, the Conservatives pledged in their 2024 general election manifesto to apply the triple lock guarantee to the personal allowance to ensure that the new state pension would remain below the tax-free threshold. The cost of this measure was stated to be £2.4billion per year by 2029/30, albeit it appears that measure as proposed would have benefitted all pensioners, not just those whose sole income is state pension.

Potential inequalities

The policy raises some questions of fairness across the wider population of taxpayers on low incomes.

Whilst exactly how the policy will be implemented is not yet clear, assuming that a ‘cut-off’ or income source criteria will be confirmed beyond which state pensioners will be required to pay the tax arising on their income, this measure will create yet another arbitrary tax cliff-edge. Cliff-edges can lead to people feeling that the system is unfair.

Indeed, in cliff-edge cases it is possible that a state pensioner with slightly more gross income than the cut-off may end up with less net income after tax than a state pensioner who benefits from this tax policy. They will not only face a tax charge, but they will also continue to face the same administrative burden they face now.

Taxpayers with a similar level of total gross income may face different tax treatment and find themselves worse off simply because their income comes from different sources.

Considering the wider taxpayer population, individuals under state pension age who receive employment income at the same level as the state pension tax cut-off will be required to pay income tax and national insurance contributions on their income above the personal allowance.

The following examples are prepared using an assumed ‘cut-off’ for collecting tax on the basic and new state pension of £12,800, i.e. that someone receiving only a basic or new state pension of up to £12,800 would not be required to pay any income tax on this income. This figure has been chosen for illustrative purposes only. 

Increased complexity

While the proposal to remove the burden of paying income tax from certain state pensioners might appear at first glance to be a simplification, there is a risk of this measure introducing increased complexity into the tax system.

This will depend on how the proposal is implemented. However, it is likely to introduce some additional complexity for HMRC in terms of administering this measure. For the state pensioner, it may not always be easy for them to identify whether they are to benefit from this proposal. There are also likely to be state pensioners who are eligible in some tax years but not in others. It could be difficult to explain to someone in this situation why they must pay tax on their state pension in one year, if they have not had to do so in a previous year. It may also be difficult to explain why some people are subject to tax and others not, if their overall income level is the same.

Wider Implications for the tax system

Measures that reduce administrative burdens, especially for those who are unable to afford to pay for professional advice, are welcome. This measure would also reduce the tax burden on some pensioners. However, consistency, fairness and certainty are also important principles in the tax system and measures need to be assessed against those wider principles. In this case, based on what is known so far, the selective nature of the relief may lead to greater confusion and a perception of unequal treatment across different groups of pensioners.

Creating a two-tier system that differentiates between taxpayers based on the source of their income rather than the overall amount risks creating resentment, distorting work and investment behaviours, and may be considered difficult to justify on equity grounds.

At worst, it could erode taxpayers’ trust in the UK tax system and discourage voluntary compliance with reporting requirements as some may feel that they are being treated unfairly.

A temporary patch, not a long-term solution

The proposal seeks to address a symptom of the interaction of two existing, misaligned tax policies – the freeze on the personal allowance, which increases the number of people drawn into income tax each year, and the pension triple lock guarantee, which ensures the state pension rises annually by at least wage growth, inflation or 2.5%.

The introduction of an arbitrary cut-off for collection of the tax effectively pauses the immediate impact of this interaction without addressing the root problem. It could be seen as a short-term workaround rather than a long-term solution.

It will benefit one group of state pensioners, by not only removing a tax liability, but also an administrative burden. Those who miss out on this relief, by however small an amount, will continue to face a tax liability, that may leave them in a financially worse position. In addition, they will continue to face the administrative burden associated with dealing with that tax liability.

Possible alternative solutions

Alternative approaches could be explored to address the growing interaction between the personal allowance and the state pension. These may be simpler and more transparent such as:

• Increase the personal allowance in line with the full new state pension, ensuring that state pensioners whose only income is the new state pension are not drawn into tax simply because the personal allowance has been frozen. This would address concerns that people on a level of income that is equal to the full new state pension should not have to pay tax.
• Reintroduce age-related personal allowances in recognition of the likelihood that older taxpayers often have different income profiles and may require a higher tax-free threshold. This would address concerns that state pensioners whose income is of a certain level should not have to pay tax.
• Bring the state pension into PAYE, allowing any tax due on the state pension in excess of the personal allowance to be collected at source from the state pension itself rather than collecting it through the simple assessment system or the pensioner’s other income. This is something we have previously proposed to the government – see here for more information. This would address concerns about the administrative complexity for state pensioners of paying small amounts of income tax through the simple assessment system.

We recognise that each of the above comes with its own potential complexities and costs, but they do deal with some of the possible issues identified with the proposed policy. 

Final thoughts

Urgent clarification is needed on the scope of this policy. We would urge the government to set out further detail about the scope of the policy, including full policy costings and an impact assessment as soon as possible. A consultation would be a helpful way to consider the policy proposal in terms of how it fits with the wider tax system and whether there are other alternative approaches that would meet the government’s objectives. The consultation could also explore possible alternative approaches to find a better long-term solution to the underlying issues created by the frozen thresholds and rising state pensions.