EIM74652 - State pension lump sum: rate of tax

Section 7(5) Finance (No2) Act 2005

See EIM74651 for details on the charge to Income Tax on a state pension lump sum.

The rate of Income Tax to be used to charge any state pension lump sum is the highest (or marginal) rate that applies when charging the individual's other income to Income Tax. Section 7(5) confirms, firstly, that if the individual isn't liable to tax for the year of assessment on their other income, no tax should be deducted from any state pension lump sum. Otherwise, one of three rates of Income Tax apply, as follows -

EXAMPLE

Suppose that Mr X is entitled to a state pension lump in tax year 2008-09 of £15,000. His other income for 2008-09 consists of earnings £22,000 and state pension of £3,000. Further suppose that in the tax year 2008/09 he is entitled to a basic personal allowance of £5,500, the starting rate limit is £2,500, the basic rate limit is £35,000 and the rates of tax are 10% (starting rate) and 22% (basic rate).

Firstly determine what Mr X's income is for tax year 2008-09?

Next determine the highest (or marginal) rate of tax for 2008-09. Of the £19,500 income, the first £2,500 is charged at the starting rate. As the remainder £17,000 (£19,500 - £2,500) does not exceed the basic rate limit of £35,000, the appropriate rate of Income Tax is the basic rate (22%).

The correct rate of tax to apply to Mr X's state pension lump is therefore the basic rate of 22%

During the application process for a state pension lump, the Department for Work and Pensions (Pension Service) will ask Mr X to self-declare his expected highest rate of Income Tax. Assuming he declares the basic rate, then tax of 22% will be withheld at the time the lump sum is paid to him. If Mr X had self-declared a rate other than basic rate, further tax would be due or tax may need repaying.

For the purpose of determining the rate of Income Tax that applies to any state pension lump sum, the special rates that are used to tax savings income (the lower rate) and dividend income (the ordinary dividend rate) falling within the basic rate band are disregarded. Similarly the upper dividend rate is disregarded for dividend income chargeable above the basic rate limit. So if an individual has any income chargeable above the basic rate of Income Tax, the higher rate (40%) will apply when charging any state pension lump to tax.

EXAMPLE

Suppose Mrs Y is entitled to a state pension lump in tax year 2008-09 of £12,000. Her other income for 2008-09 consists of earnings £12,000, bank interest of £6,000 and state pension of £3,000. Further suppose that in the tax year 2008/09 she is entitled to a basic personal allowance of £5,500, the starting rate limit is £2,500, the basic rate limit is £35,000 and the rates of tax are 10% (starting rate) and 22% (basic rate).

Firstly determine what Mrs Y's income is for tax year 2008-09?

Next determine the highest (or marginal) rate of tax for 2008-09. Of the £15,500 income, the first £2,500 is charged at the starting rate. For the purposes of the main Income Tax charging provisions the remaining £13,000 would normally be charged, part at the basic rate (£7,000) and part at the special lower rate that applies to savings income (£6,000). Following the ordering rules in Section 1A(5) ICTA the rate applicable to the highest slice of Mrs Y's would normally be 20%. But for the purposes of the state pension lump rules, the special savings and dividend rates are disregarded, so all of the remaining £13,000 is treated as income to which the basic rate (22%) applies. The highest (or marginal) rate for charging Mrs Y's state pension lump is therefore the basic rate of 22%.