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What happens in a tax year if you have deferred your state pension and you opt to take a lump sum and in the same year you have capital gains?
Apparently the rules say that both the above are taxed at your highest rate of tax for the year so which of the above takes priority?
Well it is a little confusing but in fact the answer is neither do!
Before we look at the rules we firstly need to know what total taxable income is.
Total income for tax purposes includes your taxable income including your gross wages or pension before any tax (and/or NIC) has been taken off, dividends and bank interest but it excludes any tax-free income for example, interest from ISAs or Attendance allowance.
Total taxable income is the total income that you receive (before any tax has been taken off) less your allowances. To work out taxable income we always look at the gross amount of your income. From this total you then take off your allowances to come to your total taxable income.
Capital Gains -
- do not form part of your total taxable income, because they are gains from the sale of assets, not income;
- instead you look at them separately and tax the chargeable gain at 18%.
State pension lump sum -
- is to be treated as income, but
- is not to be taken into account in working out your total taxable income
So what do these rules mean to you?
What happens is that whilst any state pension lump sum is charged to income tax it will not be added onto other income and consequently it cannot push you into a higher tax band.
Instead any state pension lump sum is taxed at the highest rate of tax that applies on your income but excluding your capital gains. So if the highest rate of tax you pay is 20% you will pay 20% tax on all of your deferred pension lump sum, no matter how large it is.
So to recap - to work out the tax due on any capital gains in the year you get a state pension lump sum - for the purposes of working out the Capital Gains Tax you ignore the lump sum - for the purposes of working out the tax on the lump sum you ignore the capital gains.
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