EIM75020 - The taxation of pension income: pension payments made in arrears or in advance
Overview
Pensions paid in arrears
Pensions paid in advance
Overview
Whether pension income is taxable when it is paid (the arising basis) or when the pensioner becomes entitled to it (the accrual basis) depends on the type of pension income. Where pension income is taxable on the accrual basis, the amount of the pension income charged to tax is the amount that the pensioner is entitled to in the tax year, regardless of what amount is actually paid.
The following types of pension income are taxable on the accrual basis:
- pensions and certain lump sums paid under a registered pension scheme
- UK social security pensions
- UK source voluntary annual payments
- UK pensions (within the scope of section 569 ITEPA 2003)
- certain overseas government pensions chargeable to tax under section 615 ITEPA 2003
These types of pension income also fall within the definition of PAYE pension income. The basis of assessment, collection and recovery of Income Tax in respect of PAYE income is explained in EIM11801 onwards. However, in broad terms PAYE collects and recovers tax as the pension is paid. Where a pension that is taxable on the accrual basis is paid in advance or in arrears, a discrepancy can arise between the amount of tax actually due and the amount of tax collected via PAYE.
There might be a difference where, for example, the amount received represents late payment of pension that the pensioner was entitled to in a previous tax year.
Alternatively, a pensioner may be paid a sum in advance of pension they will become entitled to over a few weeks or months, which may cross into a different tax year.
Pensioners are often content to pay Income Tax on the amount received in a year, as in most years the amounts accruing and received are similar. However, it is possible in certain circumstances for the amounts to be different. If a taxpayer requests the statutory basis this should be accepted.
Pensions paid in arrears
If a pension provider discovers a long-standing underpayment of pension, the underpayment is calculated and paid in a single sum. Where the provider is required to operate PAYE, they operate it on the lump sum arising which may give rise to higher rate liability for a pensioner who is usually a basic rate taxpayer. In this situation, the pensioner should contact HMRC at the end of the tax year in which the arrears were paid and supply a schedule showing the years to which underpayments are attributable (on the accrual basis), asking for the payments to be related back to the relevant years. HMRC will spread the payments back over the relevant years and recalculate liability. Underpayments in the earlier years may be set-off against the resulting overpayment in the year of the lump sum payment.
Pensions paid in advance
Where advances of pension income are made, there are 2 potential issues:
- a discrepancy may arise between when the payment is made and when it is chargeable to tax – see example 1
- when the pensioner dies, they may have received pension income to which they have not yet become entitled – see example 2
Example 1
An employee retired on 31 December 2018 and became entitled to a pension payable monthly in advance. It is taxable on the accrual basis. The pensioner received 4 payments on the first day of the month between 1 January 2019 and 5 April 2019 but is taxable for 2018 to 2019 on only 3 of them. Strictly, one-sixth of the payment received on 1 April 2019, representing 5 days of the month of April which fall into the earlier tax year, is assessable in 2018 to 2019 while the other five-sixths accrues in 2019 to 2020.
Example 2
A pensioner is entitled to a pension paid in advance. In the year of death an overpayment is made. Under the accrual basis, only amounts to which the recipient is entitled may be assessed. Consequently, the excess should not be charged to tax, even if the payer does not recover it.