Chancellor Rachel Reeves faces mounting criticism over plans that critics say amount to backdoor means-testing of the state pension through a controversial two-tier tax system set to take effect from April 2027.

The Chancellor’s proposal would create a divide between pensioners who rely exclusively on state pension income and those with any additional retirement savings, however modest.

Pensions expert Tom McPhail condemned the approach as “means-testing by proxy”, arguing the government’s decision stems from political fear rather than sound fiscal reasoning.

“The government is not doing this because it makes fiscal or practical sense, or is fair or sensible: it is doing it because it is so frightened of crossing that totemic threshold of pensioners paying income tax on the state pension because they decided to freeze it,” McPhail said.

Under the Treasury’s proposed system, retirees drawing only the state pension would avoid income tax even when payments exceed the frozen £12,570 personal allowance threshold from April 2027 onwards.

The full state pension rises to £12,548 this April through the triple lock mechanism, which guarantees increases based on the highest of inflation, wage growth or 2.5 per cent.

By 2027, a minimum 2.5 per cent rise would push payments to £12,862, breaching the tax-free threshold for the first time.

Yet pensioners with any additional income face tax demands on all earnings above £12,570, including both their private pension income and the portion of state pension exceeding the threshold.

The Treasury has confirmed that exemptions apply exclusively to those whose “sole income is the basic or new state pension”.

Former Liberal Democrat pensions minister Sir Steve Webb warned the policy would generate “all sorts of anomalies, cliff-edges and unfairnesses”, particularly affecting those with modest retirement savings.

“This is taxing people who have just got a little bit of private saving more heavily,” Mr Webb, now a partner at consultancy LCP, stated.

He added: “There is a risk of a two-tier system where people on the new state pension are protected whilst people on the old system and whose total pension is exactly the same are not protected.

There are already more than two million pensioners on the old state pension system whose pension is over the tax threshold, but no government has ever cared about this,”

The disparity extends to those receiving state earnings-related pension scheme (Serps) payments, with uncertainty surrounding their eligibility for exemptions.

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The proposals risk creating perverse incentives for retirement planning, according to industry experts who fear pensioners may withdraw modest savings prematurely to avoid tax complications.

Mike Ambery from Standard Life warned: “There are undoubtedly questions of fairness for those receiving small incomes from elsewhere who may end up paying a small amount of tax.”

He noted that “pre-retirement age poverty is on the rise and a system like this would give people a small incentive to take any modest pension pots early.”

Sir Steve Webb echoed these concerns, suggesting the policy “would provide an incentive for people to cash out their modest pension pots rather than turn them into regular income.”

He specifically warned against discouraging annuity purchases, where retirees exchange their savings for guaranteed lifetime income.

The Chancellor’s plan would benefit approximately one million pensioners from a total exceeding 13 million retirees, according to Mr Webb’s estimates.

Office for National Statistics data from 2023 indicated roughly 1.2 million retired households were “mainly reliant” on state pension income.