Inflation has dominated headlines in recent years as global events such as the Covid-19 pandemic and the war in Ukraine led to increased living costs.
During that time, we wrote about how inflation could erode the real-terms value of your savings and some ways to protect yourself. Additionally, you may have had concerns about “fiscal drag” – individuals paying more tax because of a combination of frozen thresholds and increased income.
This became a problem for many people as their earnings rose in line with inflation. Retirees may have also taken a higher level of income from their pensions to keep up with price hikes.
Fortunately, inflation has since come down and the Office for National Statistics (ONS) reports that the Consumer Prices Index (CPI) was 2.5% in the 12 months to December 2024. However, this doesn’t mean the cost of living has fallen. In fact, prices are still increasing, albeit at a slower rate. Consequently, fiscal drag could still affect your financial plan.
Read on to learn more.
Income Tax thresholds remain frozen until 2028
The amount of Income Tax you pay depends on your earnings and which tax bracket you fall into. In 2024/25, the first £12,570 of your income is tax-free. This is your “Personal Allowance”. You will then pay:
- 20% tax on income between £12,571 and £50,270
- 40% tax on income between £50,271 and £125,140
- 45% tax on income that exceeds £125,140.
In March 2021, then chancellor Rishi Sunak announced that these thresholds would be frozen until 2026. In Autumn 2022, the government extended the freeze until 2028. More recently, new chancellor Rachel Reeves confirmed that the freeze would end in April 2028.
Meanwhile, your income may have increased since 2021 and could continue to do so in the future.
More of your wealth could be pushed into the taxable range as your income increases
Whether you’re working or retired, your income may have increased in the past few years.
In fact, according to the ONS, the average weekly wage in March 2021 – excluding bonuses – was £537. By October 2024, this had increased to £656.
Similarly, the full new State Pension amount was £179.60 a week in 2021/22. This increased to £221.20 a week by 2024/25 and will continue to do so in 2025/26 because of the “triple lock”.
This guarantee means the State Pension rises by the higher of:
- The rate of inflation
- Average wage growth
- 2.5%.
In 2025/26, the full State Pension amount is set to increase to £230.25 a week. You may also draw a higher income from your personal pensions to maintain your standard of living as prices rise.
Consequently, whether you’re still in work or retired, your income could increase in the future. As tax thresholds remain frozen, this means more of your wealth may be pushed into the taxable range. In some cases, you could even move into a higher tax bracket.
According to estimates from the UK government, between 2022/23 and 2028/29, 3.7 million more people will be pulled into paying Income Tax as a result of the change. Additionally, there could be 2.7 million more higher-rate taxpayers in the same period.
While these are estimates, the figures suggest that fiscal drag could affect you moving forward. As a result, you might lose a larger portion of your wealth to Income Tax.
Fiscal drag could also affect the amount of Inheritance Tax your family pays when you’re gone
Fiscal drag could increase the amount of Income Tax you pay in the future, and it may also affect the size of the Inheritance Tax (IHT) bill your beneficiaries receive when you’re gone.
In 2024/25, you can pass on up to £325,000 without triggering an IHT charge. This is your “nil-rate band”. You may also benefit from the additional “residence nil-rate band” of £175,000 when passing your main home to a direct descendant such as a child or grandchild.
Further to this, you can pass your entire estate to a spouse or civil partner without IHT. They’ll inherit your unused nil-rate bands too, meaning you can potentially pass on up to £1 million between you.
Yet, the nil-rate band has been frozen since April 2009 and the residence nil-rate band hasn’t increased since April 2020. In her October 2024 Budget, chancellor Rachel Reeves chose to extend the current freeze to 2030.
Meanwhile, according to SunLife, the average UK house price in 2010 was £162,877. In comparison, the ONS reports that in the 12 months to November 2024 the average house price increased by 3.3%, to £290,000. Additionally, you may generate growth on your savings and investments over time.
This could mean that the value of your estate increases significantly, while the nil-rate bands stay static. As a result, your family could pay more IHT on your estate when you pass away. It’s also worth noting that recent IHT and pension changes announced in the Budget could further increase the tax burden.
It’s important that you consider these effects of fiscal drag and take steps to mitigate them, where possible. For example, increasing your pension contributions could reduce your taxable earnings and reduce the Income Tax you pay. Comprehensive estate planning may also allow you to manage your IHT liability.
Get in touch
We can help you explore different ways to protect your wealth against fiscal drag.
Please contact us at hello@ardentuk.com or call or WhatsApp us on 01904 655 330. As an award-winning financial advice company with advisers included in the 2024 VouchedFor Top Rated guide, you can be sure that we’re a bona fide company providing excellent advice and high-quality service.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning or tax planning.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
