What do you imagine is the highest effective rate at which the UK levies tax on income? 45%? 60%? 100%?
And what level of income exposes you to that rate?
How about, potentially, many thousands of percent, on income only just over the personal allowance?
The problem affects only people who reached state pension age before 6 April 2016 but deferred receiving state pension at that time and who now elect to receive the ‘arrears’ in a lump sum. And it arises because of the unique way in which the lump sum is taxed.
The lump sum is simply taxed at the highest rate at which you pay tax for the year in which you receive it, regardless of the size of the lump sum. So, if your taxable income for that year is below the personal allowance, no tax is payable on the lump sum: but if you have even £1 of income on which you pay basic rate tax, the entire lump sum is taxable at the basic rate. Similarly (and perhaps more likely) if you have even a single pound of income taxable at the higher rate, the whole lump sum is taxable at the higher rate.
Given that any lump sum is by now likely to run into several thousands of pounds, the effect can, at the extreme, be that a tiny amount of additional income can create a tax bill which is a huge multiple of the income itself – hence, in those cases, an effective tax rate of 100,000% or even more.
In fact, we have over-simplified a little: the position is sometimes even worse than we have outlined above. For reasons that are too complex to summarise in this brief note, the way in which the rules work can readily have the result that you pay tax on the lump sum even if you don’t otherwise have a tax liability for the year (or that you pay tax on it at the higher rate even if you don’t otherwise have a liability at the higher rate for the year).
The take-away is this: if you are in the group which we have described – reaching pension age before 6 April 2016 but not yet receiving state pension – do take advice on the tax consequences before electing to receive the lump sum.
For more information, please get in touch with your usual BKL contact or use our enquiry form.