2 November 2026
We’ve seen a number of instances of taxpayers receiving a pension lump sum and end up with an unexpectedly high amount of tax being deducted due to the income taking them over higher rate thresholds, over £100k so losing personal allowances etc.
Where the payment represents arrears of pension income, it is important to establish when the pension income was actually due, rather than simply relying on the date the lump sum was paid.
Pension income may be taxable by reference to earlier years
Certain pension income is taxed on an accruals basis. This means that the taxable amount is generally determined by the amount to which the pensioner became entitled in each tax year, rather than simply the amount actually received during that year.
This can be particularly relevant where a pension provider identifies a historic underpayment and makes a single payment covering several years of pension arrears.
For example, a pensioner may ordinarily receive £20,000 of pension income each year. If their pension provider subsequently discovers that they were underpaid over a number of years, they could receive a lump sum of say £50,000 in addition to their normal pension.
If the entire lump sum is initially treated as income for the year in which it is paid, the pensioner’s taxable income for that year could appear significantly higher than usual. This may result in some of the payment being taxed at a higher rate than would have applied had the pension been paid correctly in the original years.
Initial tax treatment may not reflect the final tax position
Pension providers will initially operate PAYE for the year in which the arrears are paid. As a result, the tax deducted from the lump sum may not necessarily reflect the pensioner’s ultimate tax liability on the arrears.
This will be important for individuals who would normally only pay basic-rate tax but who, due to the receipt of the arrears, move into higher-rate tax.
The initial PAYE position should therefore not automatically be regarded as the final tax position.
Arrears can potentially be allocated to the relevant tax years
You can provide details showing which tax years the arrears relate to and ask HMRC to allocate the income to those years.
A schedule should generally set out the amount of pension arrears attributable to each relevant tax year. HMRC can then recalculate the tax liabilities for those years.
Where this results in additional tax being due for earlier years, those liabilities can be taken into account against any overpayment of tax arising in the year in which the lump sum was actually received.
This can significantly change the overall tax position and may reduce the amount of tax ultimately payable compared with simply treating the entire payment as current-year income.
What should you do?
If you have received a significant pension lump sum that represents arrears, it is worth establishing:
- Which tax years the arrears relate to
- When you became entitled to the pension income
- How the pension provider has treated the payment for PAYE purposes
- How much tax has been deducted
It is important to retain any correspondence from the pension provider confirming the reason for the payment and how the arrears have been calculated.
Copies of any historic self assessment calculations may also be required.
We are here to help
Whilst the receipt of a lump sum and a tax reduction may be a nice “bonus”, this may cause you a greater inheritance tax issue. So there are further considerations required.
As ever, we are here to help you.
