Pension Clinic: record numbers are working past retirement age – but if earnings exceed the personal allowance of £12,500, those workers will pay income tax on any other income received.
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Every month, the employment figures seem to show a new record for the number of people working past the age of 65. At the turn of the century, there were fewer than half a million people in employment or self-employment aged 65 or over, but that number has now trebled to more than 1.2 million.
However, what many of these older workers may not realise is that if they combine earnings with drawing a state pension, they may end up worse off than if they defer taking their state pension until they have stopped work.
To be clear at the outset, there is no rule to stop you being in employment and drawing a state pension at the same time. But because the state pension is taxable, someone who combines their state pension with other sources of taxable income such as paid work can find they pay a lot more tax on their state pension than they would if they held off taking their pension until they had stopped work.
Delay for a boost
Consider someone who decides to work on for one year past state pension age. In 2019/20, the tax-free personal allowance is £12,500. If our older worker earns more than this amount they will use up their tax-free allowance. Any other taxable income drawn at the same time – such as a state pension – will be taxed in full. For a worker drawing a full ‘flat rate’ pension of £8,767 a year, the tax bill for a basic-rate taxpayer will be £1,753, and for a higher-rate taxpayer it will be double that at around £3,500.
Now suppose the same person decides to put off taking their state pension for one year, until they stop work. The downside is that they miss out on a full year of pension. But the good news is that they get a higher rate of state pension as a reward for deferring. The Department for Work and Pensions (DWP) currently pays an extra 5.8% for each year of deferral. In this case, when state pension starts being paid the rate will be enhanced to £9,276 per year. With each passing year of state pension income, this enhanced payment helps to make up for the year of missed pension.
But, in addition, the retired person may now be paying a lot less in income tax out of their pension. If they have very little other taxable income – perhaps only a small occupational pension – then the personal allowance of £12,500 will exceed their combined pension income and no tax at all will be paid. Remember that this contrasts with paying more than £1,700 in tax if the pension is combined with earnings.
Calculations I have undertaken for Royal London based on average life expectancies for men and women suggest that the typical working man who defers his state pension for a year will be around £3,000 better off over his retirement by doing so, and the typical working woman (with a longer life expectancy) will be around £4,000 better off . In principle, the same argument applies for deferring by two years or for longer periods. But the longer you defer, the greater the chance that you do not live long enough to recoup the missed years of pension.
Paying unnecessary tax
When it comes to the 1.2 million people working past the age of 65, Royal London estimates that nearly half are earning enough to pay income tax on their earnings but have failed to defer their state pension. As a result they are potentially paying unnecessary amounts of income tax.
However, for those who have recently started to draw a state pension but wish to defer, all is not lost. It is a little-known fact that it is possible to ‘unretire’ or, more precisely, to tell the DWP that you wish to stop receiving your state pension for a while. If you do so, your pension payments will cease – and when you restart payments they will be paid at an enhanced rate.
It is worth pointing out that deferral makes more sense for younger pensioners. For those who are well past pension age, it is unlikely that they will live long enough to recoup the pension they would lose by deferring for several years. But for those at around state pension age with an average life expectancy of over 20 years, the combination of an enhanced state pension and a more favourable tax position makes deferral well worth considering.
Steve Webb is director of policy at Royal London.