Prudent to consider tax implications for working beyond state pension age - Jenny Ross

Q I reach state pension age in 2023. I’ve built up a private pension, which I plan to draw upon in addition to my state pension, but I plan to carry on working two days per week. What are the tax implications for working beyond state pension age? I don’t expect my total income to be any more than around £45,000.

Which? research suggests an annual income of £41,000 to have a ‘luxurious’ retirement, which can involve multiple holidays. Picture: Steve Parsons/PA Wire

A You won’t be alone in continuing your employment into your mid-sixties. According to the latest data published just last week by the Office for National Statistics, more than 1.3 million people are still working past the age of 65.

And a report, published yesterday, suggested that this was largely driven by the affordability to retire. The Institute of Fiscal Studies has found that the proportion of over 65s in work has risen much more steeply in deprived areas.

Without having much information about your financial situation, I suspect your plan to carry on working is driven more by doing the job, rather than the financial element. Your combined annual income would suggest that you’re in the higher-earning end of retirees. Research carried out by Which? surveying thousands of real retirees, suggests that a couple needs an annual income of £41,000 to have a ‘luxurious’ retirement – which involves multiple holidays, new cars and expensive meals. You can read more about the research at which.co.uk/retirement.

You’re right to consider the tax implications of your retirement income. They are often misunderstood and could be a critical factor in deciding how you draw an income from your pensions.

Let’s start with your state pension. When you come to claim it, it will be paid to you ‘gross’ – i.e., without tax deducted from it. Let’s say you get the full state pension of £179.60 in the 2021-22 tax year. That’s equivalent to £9,339.20 per year, paid completely free of income tax.

Everyone gets a tax-free personal allowance – the amount you can earn before you pay any income tax. This is current £12,570. Once you get your state pension, you’ll still have £3,230.80 remaining to offset against your employment and pensions income.

Let’s say your combined income from work and pensions is £31,000. Deduct your remaining tax-free allowance and this will leave you with £27,769.20 subject to income tax. The first £2,097 will be subject to 19 per cent income tax (the starter rate). The next £10,629 will be subject to 20 per cent tax (the basic rate) and the remaining £15,043.20 will be subject to 21 per cent of tax (the intermediate rate). This will leave you with an income tax bill of £5683.30 for the 2021-22 tax year.

However, this will depend on how you draw an income from your pension. If you have a final salary or defined benefit pension, your tax affairs should be relatively straightforward, as your pension will be paid to you monthly, in a similar way to your salary.

But if you have a defined contribution pension, which accumulates into a pension ‘pot’ from which you can draw an income, the amount of tax you pay on your withdrawals will depend on how you draw them.

If, for example, you decide to tax the 25 per cent tax-free lump sum you’re entitled to from your pension, all your subsequent withdrawals could potentially be liable to income tax. But the alternative is to withdraw income from your pot in chunks without drawing on the tax-free lump sum (technically known as an uncrystallised funds pension lump sum, a truly horrible piece of jargon). With these withdrawals, the first 25 per cent is tax free, with the remaining 75 per cent subject to income tax.

There is one final twist here. Pensioners have traditionally enjoyed a significant tax break in that they no longer have to make National Insurance contributions on their employment income past state pension age (and these are not applied to pension payments). The saving is significant – National Insurance is 12 per cent on earnings between £9,568 and £50,270, and 2 per cent on anything above that amount.

However, from the 2023-24 tax year, which starts on 6 April 2023, people above the state pension age in employment will start paying a 1.25 per cent Health and Social Care levy, designed to fund some radical changes to the way that later life care is funded, as well as boosting investment in the NHS. While it won’t be a National Insurance payment, the government says that the levy is ‘is payable on an amount of earnings or profits on which an employee, employer or self-employed individual is already liable to pay a qualifying National Insurance contribution’.

Whether this will still be in place come next year remains to be seen, given that there are calls to delay the 2022 increase in National Insurance for workers under the age of 65, due to kick in on 6 April this year, to be delayed in the face of the current cost of living crisis. But the government looks set to ask working pensioners to make a bigger contribution to help fund the needs of people who need care in later life.

Jenny Ross is the editor of Which? Money