Tax on State Pension Lump Sum - SIPP contributions

Can contributions to a personal pension be used to reduce tax due on State Pension Lump Sum?

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Can pension contributions be used to reduce taxable income to zero in a way which leaves the State Pension Lump Sum untaxed? This is an obscure question about an obscure issue but I hope it's intriguing enough to get some knowledgeable answers.

For those reaching pension age before April 2016 and who chose to defer taking their State Pension, an option is available to take the deferred amount as a lump sum (the State Pension Lump Sum, SPLS) when the state pension is triggered. This lump sum is taxed at the highest rate applying to the individual's other income (that is in broad terms, it does not itself move them up the tax bands - a generous but fair provision I feel). There are various traps for the unwary, such as the zero-rate elements of dividends or savings income counting to lift the implied rate even though the taxpayer pays zero tax because of these slices. However, the simple statement is that the marginal rate paid if the SPLS is ignored is applied to the SPLS.

Now, the timeframes involved mean that at present there are a decreasing number of people in this position BUT that the lump sum will have grown pretty large. And as always, keeping money out of HMRC's clutches must be a good thing.

Specific circumstances
The Client here is still working and happy to do so. But for various reasons, they intend to take their State Pension in this tax year 23/24 in order to benefit from the lump sum. For this year, they would ordinarily be a 20% taxpayer. However, they could afford to make contributions to their personal pension (which they are not yet drawing) which would reduce their taxable income to zero. The question is, does relief on that pension contribution also impact on the tax rate applied to the SPLS so that it is also zero, or is the pension contribution "ignored" for this purpose under some obscure clause so the Client is taxed at 20% on the SPLS?

In order to have some numbers to work with, the Client is a sole trader and will have profits of £30,000 for the year. The potential lump sum is £44,700. There will probably be about £2,800 of state pension income once it gets going. No savings or dividend income is expected. Client indicates they would happily use part of the lump sum to pay into a personal pension if advantageous in reducing the tax on the lump sum.

Without the additional pension contribution, the client is a 20% taxpayer and the tax on the lump sum is 20% x £44,700 ie £8,940.

However, if the client makes a pension contribution of £20,250, this plus their personal allowance reduces their taxable income to nil and the tax rate is 0%. Seemingly that implies the tax on the lump sum is also nil, so they save/gain £8,940. Bear in mind this £20k would come from the lump sum.

Differences of opinion
Client has been told by a financial adviser that this must be wrong and the pension contribution would be disregarded for this purpose, leaving the 20% liability in place. They didn't give any reason or reference for this, although I suspect the word "obviously" was in their mind somewhere. However I can't see why this would be and take the view that the effective rate would be 0%.

Since the Client doesn't want to pay the pension contribution if it's not going to be effective in saving the tax, they want to be as certain as they can be that the scheme will work. I think it will but there's just enough doubt in my mind that I need to hear some other informed opinions. If this arrangement doesn't work, then there are other bright ideas being considered (including changing the business to a limited company and delaying to 24/25 for more complex antics).

So I suppose there are two inter-related questions here:
1: Would any personal pension contribution be disregarded (returning the tax rate to 20% on the lump sum) and why?
2: Is there any barrier to using the lump sum to pay that pension contribution (assuming it arrives in time)?

Many thanks. Your thoughts (which obviously aren't advice) would be most interesting.


Replies (6)

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By David Ex
14th Nov 2023 16:28

Might be something useful here (see references to ‘relevant UK earnings’ including “For the avoidance of doubt a pension is not classed as earnings and cannot be included in the definition of relevant UK earnings”):

EDIT: Probably misread the OP (a bit TL;DR, with due respect). If paying contributions from business earnings, surely that’s sufficient?

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Replying to David Ex:
By duncanphilpstate
14th Nov 2023 18:29

Thanks. Apologies for the TLDR - I thought the added detail would be helpful.

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paddle steamer
14th Nov 2023 18:08

My pension contributions just extend my basic rate band as tax relief at 20% is already paid direct into the scheme by HMRC.

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By Not Anonymous
14th Nov 2023 18:30

RAS (relief at source) contributions never reduce anyone's taxable income.

Eligible contributions attract basic rate tax relief from the provider so each £1 has 25% added and becomes a gross contribution of £1.25.

The gross contribution has the bonus of reducing adjusted net income (good for HICBC and tapered Personal Allowance) and increasing the basic rate band (good for avoiding higher rate tax).

To answer your specific questions,
1. I don't believe they would be disregarded. But they won't achieve what your client wants.
2. Providing he only contributes to any pertinent limit i.e. £30k gross using your example of £30k profit, then I don't think where the money comes from is a problem (pension recycling aside).

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By richard thomas
14th Nov 2023 21:11

The relevant marginal rate in s 7 F(2)A 2005 depends of what the "total income" is, not the undefined vague concept of "taxable income". No pension contributions reduce total income, except arguably those "made" under net pay arrangements. I have still yet to be pointed to the law that does allow them to be deducted "in computing" total income, but it's convenient for the players to think they can be.

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By Alison Cotton
11th Dec 2023 13:18

Is there a zero rate band for income tax anyway? Surely the basic rate is 20% (apart from starter rate for savings income and dividend rates). It is just that you have a personal allowance of up to £12,570. It is not a zero rate.

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