The state pension: should you take a lump sum?

Since April 2005 it has been possible to defer your state retirement pension and, when you do decide to draw it, to take a lump sum or extra state pension in lieu.

If you choose to receive extra state pension, you can get an extra 1% on top of your weekly state pension for every five weeks that you put off claiming. If you defer for one year, for example, this works out as an extra £10.40 per week for every £100 of pension (£540 per annum). This sounds attractive but you will have lost out on receiving £5,200 in pension in the year, so whether you win or lose depends upon how long you receive the extra pension (surviving 10 years will be the approximate ‘break even’ point).

Somewhat easier to work out is the financial benefit of the lump sum. The lump sum payment is made up of the pension you had put off claiming, plus interest at 2% higher than the Bank of England base rate.

If we assume an annual 6.5% return and an annual pension that would have been payable of £5,200, the lump sum would be:

Tax on the lump sum

A pension is counted as taxable earned income when received and a lump sum is counted as income for tax purposes. But the lump sum is not added to the rest of your income to work out your total income for tax. Instead, the rate of tax due on the lump sum payment will be the highest rate of tax paid on your other income, ignoring any of the special rates of tax that apply to interest or dividends.

For example, if you pay no tax because your other income is less than your personal allowance, you will pay no tax on your lump sum; and if your marginal rate of tax is basic rate, your lump sum payment will be taxed at basic rate.

A deferral could be attractive, therefore, if you expect to remain a higher rate taxpayer when you reach state retirement age because you are continuing to work, but will become a basic rate taxpayer when retired. It may also be appropriate in a number of scenarios where you can reduce your income in the year in which the lump sum is taken.

In summary, an interest accrual of 2% higher than base rate on a pension entitlement before tax is a very attractive return. It gets even better if you can choose which tax rate applies.