Low Incomes Tax Reforms Group

Tax Help - Pensioners

Taxing your State Pension lump sum

Putting it simply - the rate of tax that will be used on your state pension lump sum is the highest rate that applies on your other income for that tax year.

If you are not liable to tax for that tax year on your other income, no tax should be deducted from any state pension lump sum.

Otherwise, tax will be payable at one of the following two rates:
- if you are liable to tax but your taxable income does not exceed the 20% basic rate (up to £37,400 for 2010/11)
- if your taxable income exceeds the basic rate limit; the higher rate of 40%.
When working out what rate of tax should be charged on any state pension lump sum, the special rates that are used to tax savings income (the 10% savings rate (£2,440 for 2010/11) and the 20% lower rate which you will see with bank and building society interest) and dividend income (the 10% ordinary dividend rate) falling within the basic rate band are ignored.

Similarly if you are a higher rate taxpayer (you pay tax at 40% on some of your income) and you have dividend income - the upper dividend rate of 32.5% which you would pay on your dividends is not used for working out tax on the lump sum.So if you have any income chargeable above the basic 20% tax rate - you will be charged at 40% on any state pension lump.

Suppose that Luke is entitled to a state pension lump in tax year 2010/11 of £15,000. His other income for 2010/11 consists of earnings £20,600 and state pension of £5,440. For the tax year 2010/11 he gets a tax free personal allowance of £6,475. The upper limit at which you are taxed at basic rate is £37,400.

First we need to work out what Luke's income is for tax year 2010/11

Earnings £20,600
State pension £5,440
Less personal allowance (£6,475)
Total income less allowances £19,565

Next we see what the highest rate of tax will be for 2010/11. As Luke's income of £19,565 is not more than the limit of £37,400, this will be charged at the basic 20% rate.

Luke's state pension lump sum is taxed at his highest rate which is 20%.

When he applies for a state pension lump, the Department for Work and Pensions (Pension Service) will ask Luke to advise them of his expected highest rate of Income Tax. Assuming he declares the basic rate, then tax of 20% will be taken off the lump sum at the time it is paid to him.

However if Luke's other income had consisted of earnings of £40,000 and state pension of £5,000 then his highest rate of tax would be 40% and this would be the rate charged on his lump sum.

If at the end of the tax year the rate used is wrong – an overpayment of tax may arise or you may have to pay more tax to make up the difference.

Suppose Kirsten is entitled to a state pension lump in tax year 2010/11 of £12,000. Her other income for 2010/11 consists of earnings £12,975, bank interest of £6,000 and state pension of £3,000. Further suppose that in the tax year 2010/11 she is entitled to a basic personal allowance of £6,475, the basic rate limit is £37,400 and the rates of tax are 20% basic rate and 40% higher rate.

Firstly determine what Kirsten's income is for tax year 2010/11

Earnings £12,975
State pension £3,000
Savings income £6,000
Less personal allowance (£6,475)
Total income less deductions £15,500

Next determine the highest (or marginal) rate of tax for 2010/11.

For working out the rate of tax due on the lump sum the special rates that are used to tax savings income (the 10% savings rate (£2,440 for 2010/11) and the 20% lower rate which you will see with bank and building society interest) and dividend income (the 10% ordinary dividend rate) falling within the basic rate band are ignored, so all of the remaining £15,500 is treated as income to which the basic rate (20%) applies.

The highest (or marginal) rate for charging Kirsten's state pension lump is therefore the basic rate of 20%.

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