This article first appeared in This is Money – please click to view.
Tens of thousands of women have been underpaid state pension in a £1billion scandal uncovered by This is Money and our columnist Steve Webb.
Tax may be due on the large backpayments being doled out by the Department for Work and Pensions.
Heather Rogers, founder and owner of Aston Accountancy, explains what to do if you are liable for tax on your lump sum.
If you were unfortunate enough to be underpaid your state pension in the past like so many women, but have now received your backpayment from the DWP, what do you do?
State pension is taxable, although no National Insurance is payable.
The good news is that you will not have to pay tax on the entire lump sum in the year you have received it, so you will avoid a bumper income tax bill.
You will only pay tax, if applicable to your circumstances, on the pension underpayments as if they had been paid in the year they were due, and only on any pension underpayment in the current, or the last four full tax years.
Any years prior can be ignored.
For example: you received your backpayment for the years 2014/15-2020/21. The backpayment due for the years, 2020/21, 2019/20, 2018/19 and 2017/18 will be taxable, the rest can be ignored.
Whether you will be liable for income tax and at what rate – 20 per cent, 40 per cent or 45 per cent – will depend on your total income, including your backpayment, for any one year.
As a rule of thumb, bear in mind that the personal allowance, the threshold at which you typically start having to pay income tax, was the following in recent years.
2017/18 – £11,500
2018/19 – £11,850
2019/20 – £12,500
2020/21 – £12,570
In theory, HMRC should be informed by the DWP about your backpayment and should raise any appropriate assessment.
However, beware that I have not yet seen this in practice! In fact, I have seen HMRC try to tax the entire lump sum in the year it was received, or tax more than four years’ worth of pension backpayment.
It is therefore best to check with an accountant to ensure that you only pay the tax that you owe.
However, if you cannot afford to seek professional advice, here is a step-by-step guide to what to do if you are affected.
Get a breakdown of your backpayment from the DWP
Heather Rogers: An accountant explains what to do about any tax due on your state pension backpayment
The first step is to make sure you have a breakdown by tax year from the DWP.
This should have come with your letter about your backpayment.
However, in my experience with affected clients, this often does not happen and the recipient merely receives a letter confirming the amount and the period covered, which could be quite a few years’ worth.
If you do not have a breakdown of your backpayment by tax year then contact the DWP, quoting your name and National Insurance number. Here are the contact details.
Address: The Pension Service, 15 Post Handling Site B, Wolverhampton WV99 1AS
Phone: 0800 731 7898
Fax: 01925 793101
Textphone (for those with speech or hearing difficulties): 0800 731 7339
Opening hours: 8am to 7.30pm Monday to Friday
Prepare for a long wait on the phone at this time, due to so many of the staff still working from home! If your patience expires, do write to them, although again, you will have to wait for a reply.
Work out whether there is tax to pay
Once you have received a letter confirming the breakdown of the underpaid state pension by tax year, then you need to work out if you have any tax to pay on the backpayment.
1. If you fill out a self-assessment tax return
Whatever you do, don’t report the total lump sum on your self-assessment tax return in the year you receive it, or you will be taxed on the whole lot and have to try to claw it back.
Only report the backpayment appropriate for that year. So for example, if you received a lump sum in 2020/21 of £13,500 and £3,250 related to 2020/21, then the £3,250 would be reported on your 2020/21 tax return, along with the rest of the state pension received for that year, pre uplift.
This is why it is so important to have a breakdown by tax year.
We have received many enquiries from bereaved adult children about their late parents’ state pensions.
The DWP does not know how many pensioners have died while unwittingly being underpaid, as it normally destroys records four years after the death of a pensioner and their surviving spouse.
If you think a late relative could have been affected, we explain what to do and what details to send the DWP here.
Heather Rogers explains what to do about inheritance tax if you receive a backpayment owed to a deceased relative here.
For the earlier years, in our example 2017/18 – 2019/20, it is easier to advise HMRC by letter, and quote your National Insurance number and your UTR (Unique Taxpayer Reference, the 10 digit reference on your tax return).
Enclose a copy of the letter from the DWP confirming the backpayment by tax year but make sure you reference that only the last four years are taxable, as I hate to say so, but this seems not to be widely known at HMRC!
If you have an accountant acting for you with regards to your tax affairs, do make sure you advise them of the pension backpayment and the split by tax years.
You should receive tax assessments from HMRC, and do check them carefully. If any tax is being collected through tax codes on private pensions, for example, do make sure you keep an eye on your code, as often information does not get updated.
Also, check that HMRC has your new annual state pension correct on any tax codes going forward to avoid any tax shortfalls.
If you have any problems, do consider getting an accountant to help if you can afford this. It can often save a lot of stress.
2. If you don’t fill out a self-assessment tax return
Write to HMRC quoting your National Insurance number and enclosing a copy of the letter from the DWP showing the split by tax years.
Again, ensure that you check the assessment you will receive back from HMRC, and make sure you are not being taxed on pension backpayments prior to the four-year rule. Again, check tax codes and the assessments carefully.
Could you receive a penalty if you don’t inform HMRC about your lump sum?
If you fail to advise HMRC of income you have received which is untaxed you could receive a penalty.
However, you would have a defence if you could prove HMRC had the information in its possession and failed to act upon it, especially if HMRC received the information from more than one source – for example, the person in receipt of the backpayment and the DWP.
In fact, you can ask HMRC to write off the tax you owe if all of the following apply:
– HMRC has not used the information provided to them; in other words, you have written and you can prove you have written to advise of the additional income you have received;
– HMRC told you about the tax you owe more than 12 months after the end of the tax year in which they received your information; but tax owed from the last tax year is unlikely to be written off no matter when HMRC received information about your change of circumstances;
– You have a reasonable belief that your tax affairs are in order for the years you owe the tax and HMRC agree.
You can ask HMRC to write off the tax under an extra-statutory concession called ‘ESC A19’ – this might become relevant to some people given the length of time HMRC is taking to deal with and respond to taxpayers at present.
Make a complaint if you do not hear from HMRC
HMRC is incredibly slow at the moment and I have many letters which have not yet received a response exceeding 12 months.
If this happens to you, do not hesitate to put in a formal complaint. The details of how to do this are here.
If you write a letter, be aware that HMRC has been opening post rather erratically in the pandemic, so put FORMAL COMPLAINT on the envelope to get it noticed.