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Deferred State Pension: What is the tax position when you receive a lump sum after deferring it under pre-2016 rules?
I deferred my state pension 12 years ago and have no intention of claiming it in the near future, opting instead to receive a lump sum in a few years when I am over 80.
Am I at risk of being taxed on the lump sum payment?
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Steve Webb answers: I see that you reached retirement age before April 6, 2016 and are therefore included in the “old” state pension system.
That system made deferring the state pension relatively attractive in certain circumstances, so it’s worth looking at your options before looking specifically at tax.
As you know, when you finally decide to claim your state pension, you will be offered two main options.
The first is to receive a significantly enhanced regular pension. To be more precise, your pension will increase by 10.4 percent for each full year of deferral.
In his case, he would be offered more than double the regular pension he would receive now if he had not postponed his application.
The second option is to receive all the pension payments you have missed so far in the form of a lump sum plus interest.
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In terms of your options now, if you were thinking of taking the enhanced regular pension option, there would be a strong reason to consider ending your deferral period soon.
Although you receive an additional 10.4 percent on your pension for each year of deferral, that increase is the same regardless of whether you are newly retired or over age 70.
But in the latter case, on average, you will have far fewer years to collect that enhanced pension. In short, therefore, accumulating a higher regular pension becomes less attractive with each year of deferral.
Instead, what you are seeking is the lost pension plus interest.
The interest rate is set at the Bank of England base rate plus an additional 2%. When you reached retirement age, the base rate was just 0.5%, so you earned 2.5% interest on your deferred pension.
But at the Bank of England’s base rate, which is now 5.25%, you are earning 7.25% on your deferred state pension. That’s a pretty impressive rate for what is, in effect, a “risk-free investment”.
This brings us to the question of taxes.
If you opt for a higher regular pension, your state pension will simply be added to all your other sources of taxable income.
Since you currently seem to be getting by without any of your state pension, I’m assuming you have a decent amount of other income.
With the Bank of England’s base rate now at 5.25%, you’re earning 7.25% on your deferred state pension. That’s a pretty impressive rate for what is, in effect, a “risk-free investment”.
If so, adding a large regular state pension could potentially push you into the highest rate tax bracket, with 40 per cent (or more) of your deferred payout reclaimed in income tax.
However, if you opt for a lump sum, there is good news.
When HMRC calculates the tax due on your State Pension lump sum, it looks at your income tax rate *excluding* the lump sum and then applies that rate to your entire lump sum.
As long as you are currently only a basic rate taxpayer, this means you will only pay 20 per cent tax on the total sum.
This is despite the fact that 12 years of state pension – plus interest – could easily have taken him into the 40 per cent tax threshold.
It is probably fair to also raise the question of what would happen in the unfortunate event that you were to die without ever having collected your state pension.
I covered this issue in more detail in a previous column: If you delay paying your state pension and die, your heirs may lose out.
Being under the “old” state pension system, any surviving spouse could inherit the pension you did not receive as a taxable lump sum or could benefit from an “additional state pension” on top of their own pension.
But if you don’t have a spouse, the money you lost will largely be lost, except that your heirs could claim three months of retroactive pension.
Finally, for the sake of completeness, I should mention that for people who reached retirement age on or after 6 April 2016, the option of a lump sum plus interest is no longer available.
Instead, you will simply receive an additional 1 per cent on your state pension for every 9 weeks of deferral, which equates to an extra 5.8 per cent on an annual basis.
If someone who is taking advantage of the new state pension system has deferred their state pension and dies before receiving it, the rules on what a surviving spouse can receive are set out here: Inheriting a deferred state pension.
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