avoiding income tax on pension deferral lump sums

kidmugsy

This got no response on the pensions forum: would anyone here like to comment?

Matilda is thinking of stopping her deferral of her State Retirement Pension and is due a lump sum of £40k. Naturally she would rather not pay £8k income tax on it. Her taxable income for this tax year (including her newly started SRP) will be £20k. What to do?

On her taxable income she is due income tax of 0.2 x (£20k - £10k) = £2000. And her 20% tax rate will apply to all of her £40k too, cos them's the rules.

Now suppose she invests in an EIS [edit: or VCT], a tax-advantaged investment scheme. She bungs in £6700 which wipes out an income tax liability of 30% x £6700 = £2000 plus a tenner left over. But that means that she is now a 0% taxpayer and therefore [and here is the nub of it] she should avoid paying any tax on her £40k. So now she's better off by £8k - £6.7k = £1300, plus she owns the EIS investment. Or, perhaps even better, she invests only £4k, and not in an EIS but in a riskier thing called an SEIS. That wipes out a tax liability of 50% x £4k = £2k. So now she's better off by (£8k - £4k) = £4k plus she owns the SEIS investment.

Now then, oh ye of mighty professional expertise, would this work?

purdyoaten

I am strongly of the view that this would not work. Relief on EIS is given by way of a tax reducer, not as an allowance, which I believe you understand. I believe that Matilda would remain a 20% taxpayer who happens to have an EIS investment which creates a credit against her tax liability. I could be proved incorrect and will delve further but I believe that I did come across this scenarion before in my dim and distant past.

By way of example, I believe that the following is true:

Earns £15000 with personal allowance of £10000 - tax liability of £1000.

EIS investment of £3333 reduces tax liability to NIL.

If this person had other income, the tax liability would be calculated by reference to the £15000 earned i.e. £5000 liable at 20% and the other income would attract tax at that rate until he reached the higher rate threshold, HAVING USED UP £5000 OF THE BASIC RATE BAND. The pension income, under the deferred rules would all be taxable at 20%.

kidmugsy

purdyoaten wrote: »

I could be proved incorrect and will delve further .

I should be grateful for that.

purdyoaten

kidmugsy wrote: »

I should be grateful for that.

Having researched this a bit more and spoken to one of my HMRC 'friends' I fear that I am correct in this - the position is really much simpler than my previous explanation.

Income Tax relief
[FONT=Helvetica 55 Roman,Helvetica 55 Roman][FONT=Helvetica 55 Roman,Helvetica 55 Roman]Relief for subscription in an EIS company is given as a tax reducer at the lower of:-(i) 30% of the amount subscribed, maximum subscription qualifying for tax relief. The maximum amount an individual can invest is £1m.
(ii) The individual’s tax liability (before reductions for any other tax reducers

The fact is that Matilda's tax liabilty must be calculated before any tax reducers come into play and this would include the state pension amount. This works in exactly the same way as the Married Couples allowance for the elderly at the moment.

In reality, you have chosen to omit this income, in order to reduce the tax payable to NIL after EIS relief before bringing the same income into the calculation.

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kidmugsy

purdyoaten wrote: »

The fact is that Matilda's tax liabilty must be calculated before any tax reducers come into play and this would include the state pension amount.

Thank you. The swine! Ah well.

Then Matilda would be well advised to take her deferral reward as extra pension.

Cook_County

Not exactly. Matilda should move to a treaty partner country that has a lower rate of tax than the UK and become treaty resident there. She could achieve a much lower rate of tax than by staying in the UK.

kidmugsy

Cook_County wrote: »

Not exactly. Matilda should move to a treaty partner country that has a lower rate of tax than the UK and become treaty resident there. She could achieve a much lower rate of tax than by staying in the UK.

Wouldn't the lower rate apply to both extra pension and lump sum? In fact, if the initial tax rate were low but then increased rapidly, she might be worse off with a lump sum in Lowtaxia than in the UK.