Anyone reaching state pension age can defer taking it, say, until they stop working. This will entitle them to a higher regular pension or a lump sum payment. They can also use deferral to obtain a tax saving. How does this work?
State Pension deferral
Radical changes to state pensions are on the way, but it’s still possible to defer claiming it beyond the normal pension age. Anyone doing this will be compensated by increased regular pension payments or a lump sum. They can choose which to take but the tax consequences might play an important part in this decision.
Tax on increased pension
If someone defers their state pension by five weeks or more and then opts for an increased pension, the tax position is straight forward; they’ll simply be taxed on the amount of pension they receive. Nevertheless, this will save them tax if they’re currently a higher or additional rate taxpayer but will be taxable at a lower rate by the time they take the increased pension.
Tax on lump sum
By contrast, the tax rules for lump sums are rather quirky. These say that a lump sum will be taxed at the highest rate payable on other income in the year the lump sum is received. But oddly, as the example below illustrates, it doesn’t get added to the other income to work out the rates of tax payable.
Example. Jane is the sole director/shareholder of Acom Ltd, with annual income of around £80,000 meaning she pays tax at 40%. In late March 2014 she’ll be entitled to £12,000 per year state pension. If she takes this she will pay £4,800 tax on it in 2014/15 (£12,000 x 40%) but because her intention is to stop working midway through 2014, she decides to defer her pension until March 2015. She estimates her gross income for 2014/15 will be £35,000 putting her in the 20% tax bracket. Tax on her pension lump sum, at £12,000, will be 20% even though if this were added to her other income it would normally push her into the 40% rate. By taking deferred pension as a lump sum Jane has saved tax of £2,400 (£12,000 x (40%-20%)). But she can do better.
Tip. If Jane reduces her tax rate on other income to zero for 2014/15 she would avoid paying any tax on it. And because she’s a director she’s in a position to do this.
Jane can bring forward some of her 2014/15 income from Acom into 2013/14. Her aim is to lower her income for the later year to less than her personal tax-free allowances, i.e. £10,500. At this level she won’t pay income tax and so the rate due on her pension lump sum will be zero. She’ll save £4,800 tax on her state pension compared to the position had she not deferred it.
Tip. Jade can bring forward her income from Acom by voting herself salary or dividends earlier than she normally would, i.e. in 2013/14 rather than 2014/15. This will have little or no effect on her company’s cash flow until she needs to draw it. But it will reduce her taxable income and, therefore, the tax payable on her state pension lump sum.
Deferred state pension lump sums aren’t added to other income to work out the tax payable on them, e.g. where tax is payable at 20% on other income this will also be the rate applicable to the pension lump sum. So shifting income from the year a lump sum is received can reduce the rate of tax payable on it.