Q&A: deferred state pension and tax liability

In our regular Q&A series from Croner Taxwise, tax adviser, Julian Payne explores the implications of income tax when drawing money from a deferred state pension

Q. Anne (aged 66) and Brian (aged 68) are a couple who could have started to draw their state pension a few years ago but they chose instead to keep on running their own trading company and defer taking it.

A. From a look at their records for 2018-19, it is clear that they both started to draw on their state pension in the year but with different effects on their income tax calculations for the year because Brian received a lump sum but Anne did not.

Brian’s date of birth (13 March-1951) gave him a state retirement date of 13-3-2016 when he reached 65. Anne’s date of birth (17 April 1953) gave her a state retirement date of 6 July 2016. (Retirement dates can be checked using the calculator).

Anne’s retirement date is only a few months after Brian’s despite the age gap of approximately two years because of regulations introduced to harmonise the pensions of men and women.

Because Anne’s state retirement date was after 5 April 2016, the effect of deferring is that she will get a higher weekly amount of pension.

Brian also might have opted for getting a higher pension as a result of deferring. However, because Brian’s retirement date was before 6 April 2016, he had the choice of a pension of a lump sum.

The lump sum, a ‘social security pension lump sum’, has a specific piece of legislation (sections 7 and 8, Finance Act (No.2) 2005) detailing the tax rules.

The result can look a bit strange if you do not know what to expect. The legislation says that the lump sum is income but should not be included in the individual’s total income (so, it does not affect how the other elements of the person’s income are taxed).

The tax on it is an amount of income tax that comes into the calculation of the person’s income tax bill for the year, right at the end of the calculation at step seven, s23 Income Tax Act  2007(ITA 2007). The rate applied to the lump sum is worked out by a two-step method:

  1. Find the amount of income obtained after step three of the income tax calculation (broadly the total income after relief for losses, qualifying interest, share loss relief, relief for gifts of qualifying investments to charity and personal allowances). Note that the lump sum itself cannot result in abatement of personal allowances.
  2. If the result is nil at this point, then no tax will be paid on the lump sum. If it does not exceed the basic rate limit (£34,500 for 2018-19), tax at 20%. If it exceeds the basic rate limit but not the higher rate limit (£150,000 in 2018-19), tax at 40%. If the result exceeds the higher rate limit then tax at 45%. However, if the pensioner is a Welsh or Scottish taxpayer, different limits will be needed.

If Brian had planned in advance as he was going to get a lump sum, it might have been possible to minimise the tax on it by keeping down his other income for that year (eg, by taking a smaller dividend from his company).

However, anything that raises the thresholds for the tax bands could be used to drop the tax on the lump sum to a lower rate.

If the tax year in which the pension started has already closed then it is too late to achieve that with contributions to a personal pension scheme but that result could still be achieved by relating back into the tax year a Gift Aid donation made during the 10 months following it.

About the author

Julian Payne, tax adviser at Croner Taxwise, tel: 0333 251 2337

This article first appeared on Croner Taxwise

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