Deferring the state pension – how does it work, and is it worthwhile?

It has been a longstanding feature of the state pension system that you don’t have to take your state pension as soon as you reach state pension age. In fact, many people don’t realise that the state pension only starts to be paid when an active claim is made. Whilst individuals are generally warned no later than two months before state pension age that they may wish to make a claim, they are not required to do so.

Until the state pension reforms of April 2016, deferral was actively encouraged by the government. Individuals who deferred their state pension had two options when the time came to take their pension.

  • The first was to take all the pension payments they had deferred in the form of a lump-sum, with interest added at 2% above the Bank of England’s base rate. This lump sum was taxed at the individual’s marginal rate of tax.
  • The other alternative was to draw a regular state pension at a significantly enhanced rate. Under the old rules, each year of deferral meant that the pension would be paid at a rate 10.4% higher when it was finally drawn. This meant that even those with average life expectancies could expect to be net winners over their lifetime by deferring taking their state pension.

In April 2016, two major changes were made.

  • The first was to abolish the option of taking deferred pension as a lump sum. It was felt that this over-complicated the system (as the relative advantage of taking a lump sum over taking an enhanced pension could fluctuate over time depending on interest rates) and individuals who wanted a lump sum could simply take their pension and save it up for themselves if they could do without it for a period.
  • The second change was that the increase for deferring was reduced. Rather than a 10.4% enhancement for each year of deferral, the enhancement is now the equivalent of 1% for every 9 weeks it is deferred. This works out as just under 5.8% for every 52 weeks. This is regarded by the Government Actuary as being broadly ‘neutral’ in the sense that (ignoring taxation) the Exchequer is largely indifferent over time as to whether people take their pension at pension age or defer it.

However, because state pensions count as taxable income, it is important for those who are still in work past state pension age to consider carefully whether taking a state pension as soon as it is possible to do so is the best idea. To illustrate this point, let’s consider two scenarios.

Case study A: individual with no other income in retirement except state pension

An individual who is currently in full-time work and works for one year past state pension age.

  • they currently earn £25,500 a year
  • the tax-free personal allowance is £12,570 in 2022/23
  • the full flat rate state pension is £9,627.80 a year in 2022/23

This individual is still working at age 66 and is considering the following two options:

  • to draw their state pension immediately at their state pension age of 66, or
  • to defer taking their state pension until they stop work in a year’s time

In the first option, the state pension is added to their earnings when income tax is calculated. Since their earnings exceed the annual tax-free personal allowance, the whole of the state pension will be subject to income tax at 20% (if in England).

In the second option, a higher rate of state pension is payable (because they deferred by a year) and no tax is paid because the individual has no other taxable income once they stop working.

The impact on their total retirement will depend on how long they live, and on average, this will be longer for women than for men.

The next two boxes show the outcome for a male and for a female with average life expectancy at 66. (To reduce complexity, we have ignored future indexation of the state pension and of the increment to the state pension for deferral).

Example for a male

Scenario A1. Male, takes state pension immediately and lives for another 19 years
Total state pension: standard rate £9,627.80 x 19 years                    £182,928.20
Minus tax on state pension in year 1 £9,627.80 @ 20% £1,925.56
Net income over retirement   £181,002.64
Scenario A2. Male, defers state pension one year and lives for another 18 years
Total state pension: enhanced rate £9,627.80 x 1.057771 x 18 years £183,311.96
Minus tax on state pension in year 1   £0
Net income over retirement   £183,311.96

1The enhancement is 1% for every 9 weeks it is deferred. 52/9 = 5.777

Gain from deferral over their lifetime £2,309.32

Example for a female

Scenario A3. Female, takes state pension immediately and lives for another 21 years
Total state pension: standard rate £9,627.80 x 21 years                 £202,183.80
Minus tax on state pension in year 1 £9,627.80 @ 20% £1,925.56
Net income over retirement   £200,258.24
Scenario A4. Female, defers state pension one year and lives for further 20 years
Total state pension: enhanced rate £9,627.80 x 1.05777 x 20 years £203,679.96
Minus tax on state pension in year 1   £0
Net income over retirement   £203,679.96

Gain from deferral over their lifetime £3,421.72

In both cases the increase is over £2,000. By deferring their state pension until they stop working there is a tax saving of £1,925.56 because the state pension is never subject to income tax (it is not drawn until there is no other taxable income and it falls beneath the personal allowance). However, the female gained more than the male because she has an extra couple of years during which the enhanced rate of state pension for deferral was paid.

Case Study B: Individual with a personal pension of £10,300 a year

Next, let’s consider the case of someone who also has a personal pension and starts to draw their benefits from it at age 66.

  • they currently earn £25,500 a year
  • the tax-free personal allowance is £12,570 in 2022/23
  • the full flat rate state pension is £9,627.80 a year in 2022/23
  • their personal pension is paying them £10,300 a year

The significance of this is that the retired person will pay some tax on their retirement pension because the combination of their personal pension and their state pension takes them above the £12,570 personal tax allowance. This means the saving from deferral will be smaller than in the first case study.

Let’s look at the calculations from Case Study A, but now taking account of the personal pension.

Example for a male

Scenario B1. Male, takes state pension immediately and lives for a further 19 years
Total state pension: standard rate

£9,627.80 x 19 years                   

£182,928.20

Minus tax on state pension in year 1

£9,627.80 @ 20%

£1,925.56

Minus tax on state pension in years 2 to 19

£7,357.802 @ 20% x 18

£26,488.08

Net income over retirement

 

£154,514.56

2 Some of the personal allowance has been used up with the income from the personal pension. the balance remaining for the state pension is £12,570 - £10,300 = £2,270. £9,627.80 - £2,270 =  £7,357.80

Scenario B2. Male, defers state pension one year and lives for a further 18 years
Total state pension: enhanced rate £9,627.80 x 1.05777 x 18 years £183,311.96
Minus tax on state pension for 18 years £7,9143 @ 20% x 18 £28,490.40
Net income over retirement   £154,821.56

3 Some of the personal allowance has been used up with the income from the personal pension. The balance remaining for the state pension is £12,570 - £10,300 = £2,270. £10,184 - £2,270 =  £7,914.

Gain from deferral over their lifetime £307

Example for a female

Scenario B3. Female, takes state pension immediately and lives for a further 21 years
Total state pension: standard rate £9,627.80 x 21 years                  £202,183.80
Minus tax on state pension in year 1 £9,627.80 @ 20% £1,925.56
Minus tax on state pension in years 2 to 21 £7,357.80 @ 20% x 20 £29,431.20
Net income over retirement   £170,827.04
Scenario B4. Female, defers state pension one year and lives for a further 20 years
Total state pension: enhanced rate

£9,627.80 x 1.05777 x 20 years

£203,679.96

Minus tax on state pension for 20 years

£7,914.00 @ 20% x 20

£31,656.00

Net income over retirement

 

£172,023.96

Gain from deferral over their lifetime £1,196.92

The key difference in Case Study B is that the individual is already using up £10,300 of their £12,570 tax-free personal allowance because of their personal pension. This means that only the remaining £7,357.80 (£12,570 - £10,300 = £2,270) is available to shield their state pension against tax, so the potential upside to deferral is smaller. Nonetheless, by deferring, the individual still ends up £307 better off if they are a male with average life expectancy and £1,196.92 if they are a female.

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