- Deferred pension options: higher regular or lump sum
- Lump sum taxed at current income rate
- Higher tax if opting for regular pension
You attained pension age before April 6, 2016; hence, you fall under the ‘old’ state pension scheme.
That method made deferring your state pension appealing in certain circumstances, so it’s worth considering your options before focusing on taxation.
As you know, when you claim your state pension, you will be given two significant options.
The first option is to accept a greatly improved regular pension. Specifically, your pension will increase by 10.4% for each full year of deferral.
In your situation, you would be offered more than double the usual pension you would have received if you hadn’t deferred.
The second option is to get a lump amount plus interest for all previous pension payments foregone.
Regarding your current options, if you are considering the enhanced regular pension option, there is a strong justification for ending your deferral period as soon as possible.
Although you receive an additional 10.4 percent on your pension for each year of deferral, this increase applies whether you are just retired or in your late seventies.
However, in the latter instance, you will have significantly fewer years to benefit from the higher pension. In short, accumulating a larger regular pension becomes less appealing with each year of deferral.
Instead, you’re going for the missing pension and interest.
The interest rate is 2% above the Bank of England’s base rate. The base rate was only 0.5 percent when you initially reached pension age. Thus, you earned 2.5 percent interest on your deferred pension.
However, with the Bank of England’s base rate now at 5.25 percent, you receive 7.25 percent on your deferred state pension. This is an outstanding interest rate for a ‘risk-free investment.’
This takes us to the subject of taxation.
If you choose a more excellent regular pension, your state pension will be added to all other forms of taxable income.
Given that you appear to be getting by without your state pension, I’m betting you have a good source of additional money.
If so, adding a hefty regular state pension may push you into a higher tax category, with 40% (or more) of your deferral benefit clawed back in income tax.
However, there is some good news if you go with a lump payment.
When HMRC calculates the tax due on your state pension lump sum, they take your income tax rate, excluding the lump sum, and apply it to the entire lump sum.
Assuming you are now a basic rate taxpayer, you will only pay 20% tax on the total lump payment.
This is even though 12 years of state pension, plus interest, might have pushed you into the 40% tax rate.
It is perhaps only right that I bring up the question of what would happen if you died without ever receiving your state pension.
In a previous column, I discussed how if you postpone receiving your state pension and then die, your heirs may suffer financial consequences.
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As you are a member of the ‘old’ state pension system, any surviving spouse may inherit the pension you did not take as a taxable lump payment or benefit from an ‘additional state pension’ on their own.
However, if you do not have a spouse, most of the money you have missed out on would be forfeited, with the exception that your heirs may be able to receive three months’ backdated pension.
Finally, for completeness, I should clarify that the option of a lump amount plus interest is no longer accessible for persons who attained pension age after April 6, 2016.
Instead, you will earn an additional 1% on your state pension for every nine weeks of deferral, 5.8% every year.
Suppose someone eligible for the new state pension system has postponed their state pension and dies before taking it. In that case, the rules governing what a surviving spouse can receive are as follows: inheriting a postponed state pension.
