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HMRC internal manual

Employment Income Manual

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HM Revenue & Customs
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State pension lump sum: rate of tax

Section 7(5) Finance (No2) Act 2005See

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

Tax years 2006/07 and 2007/08 onlyThe 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 -

* if the individual is liable to tax but their taxable income does not exceed the starting rate limit; the starting rate 
* if the individual's taxable income is above the starting rate limit but does not exceed the basic rate limit; the basic rate
* if the individual's taxable income exceeds the basic rate limit; the higher rate.EXAMPLE

Suppose Mrs Y aged 64 is entitled to a state pension lump in tax year 2007-08 of £12,000. Her other income for 2007-08 consists of earnings £12,000, bank interest of £6,000 and state pension of £3,000. Further suppose that in the tax year 2007-08 she is entitled to a basic personal allowance of £5,225, the starting rate limit is £2,230, the basic rate limit is £34,600 and the rates of tax are 10% (starting rate) and 22% (basic rate).

Firstly determine what Mrs Y’s income is for tax year 2007-08?

Earnings £12,000  
     
State pension £3,000  
Savings income £6,000  
Less personal allowance (£5,225)  
Total income less deductions £15,775  

Next determine the highest (or marginal) rate of tax for 2007-08. Of the £15,775 income, the first £2,230 is charged at the starting rate (10%). For the purposes of the main Income Tax charging provisions the remaining £13,545 would normally be charged, part at the basic rate (22%) (£7,545) and part at the special lower rate that applies to savings income (£6,000). Following the ordering rules in Section 16 ITA 2007 the rate applicable to the highest slice of Mrs Y’s would normally be 20% (the special savings rate). But for the purposes of the state pension lump rules, the special savings and dividend rates are disregarded, so all of the remaining £13,545 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%.

Tax years 2008/09 onwardsThe 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) as amended by section 5(7) and paragraph 64 of Schedule 1 Finance Act 2008 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 two rates of Income Tax apply, as follows -

  • if the individual’s taxable income is greater than nil but does not exceed the basic rate limit; the basic rate
  • if the individual’s taxable income exceeds the basic rate limit; the higher rate.EXAMPLE

Suppose that Mr X is entitled to a state pension lump in tax year 2009-10 of £15,000. His other income for 2009-10 consists of earnings £22,000 and state pension of £3,000. Further suppose that in the tax year 2009/10 he is entitled to a personal allowance of £9,100, the basic rate limit is £35,000 and the rate of tax is 20% (basic rate).

Firstly determine what Mr X’s income is for tax year 2009-10?

Earnings £22,000  
     
State pension £3,000  
Less personal allowance (£9,100)  
Total income less deductions £15,900  

Next determine the highest (or marginal) rate of tax for 2009-10. As the £15,900 income does not exceed the basic rate limit of £35,000, the appropriate rate of Income Tax is the basic rate (20%).

The correct rate of tax to apply to Mr X’s state pension lump is therefore the basic rate of 20%

Tax deducted by DWPDuring 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 20% 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 rate that is used to tax dividend income (the ordinary dividend rate) falling within the basic rate band is 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.