State Pension lump sum – Tax saving Opportunity?
If you are entitled to your state pension, you may have decided to defer the receipt of the pension.
Similarly, if you are approaching state pension age, you may consider deferring the pension.
Why would you want to defer?
You may have chosen to defer your state pension perhaps due to the level of your other income which meant that receiving your state pension would cause a substantial increase in your overall tax liability or perhaps you simply didn’t need the income? When you decide that you wish to claim the deferred element of your state pension, this will be paid to you as a taxable lump sum by HMRC.
The Tax Treatment and what tax will I pay?
The tax rate that applies to the lump sum depends upon the tax rate that applies to your income for the year in which you receive your lump sum. It is important to understand that the appropriate tax rate will be applied to the full sum, irrespective of the size of the payment.
So if you are a basic rate taxpayer (ignoring reliefs for personal pension contributions and gift aid donations), before the lump sum is added to your income, then you will pay 20% tax on the lump sum, even if the lump sum takes your income into the higher (40%) or even additional rate (45%) of tax.
If you are a higher rate taxpayer, before the lump sum is added to your income, then you will pay 40% tax on the lump sum, even if the lump sum takes your income into the additional rate (45%) of tax.
Finally, if you are a non taxpayer, before the lump sum is added to your income, then the lump sum will not be subject to any income tax, again regardless of the size of the lump sum payment.
The tax planning opportunity
Therefore the tax saving opportunity comes if you are able to pre-organise your income so that you are not liable to any tax. This is particularly appropriate if you are a director of your own company and are able to reduce your salary to say £10,000 to keep your income below the personal allowance threshold, take your lump sum and delay any dividends until the next tax year.
The result is that you have gone from a position where taking your state pension, at the time of entitlement, would have meant that you would have incurred a tax liability to a position where you have received the lump sum (effectively the deferred pension income) tax free.
If you do not like the thought of managing your income so that it is below your personal allowance, then you could of course keep your income below the higher rate threshold so that only 20% tax is payable on the lump sum as opposed to perhaps 40%/45% if the state pension was taken when you were entitled to it.
To find out more about this article, or for specialised tax advice, please contact Peter Vassallo