As you are probably aware, since April 2015, it has been possible to take as much as you like from your pension (assuming it is a defined contribution plan and the provider has amended their rules) and, at any time once you are age 55 (in most cases).
However, determining how much tax will be deducted by the pension provider can be quite a challenge. A number of our clients have been unaware of how the tax rules are applied; I hope the following guidance will provide some clarity around this issue.
Income can be withdrawn from appropriately flexible schemes either under Flexible Drawdown or by taking an Uncrystallised Fund Pension Lump Sum (UFPLS). In both cases tax will be due on any income (although not the pension commencement lump sum component, which is paid tax-free) at the recipient’s marginal rate of income tax. The amount of tax deducted by the provider is processed under the Pay as You Earn (PAYE) scheme but the amounts deducted can sometimes provide an unwelcome surprise.
What happens when income is first taken?
If the pension scheme does not hold an up-to-date tax code and the individual does not have a P45 for the current tax year, the scheme administrator must tax any payment under the emergency tax rules. Where this is the case, it is assumed that the amount being withdrawn will continue to be paid each month, even if it is a one-off payment. This is known as the ‘Month 1’ basis and the administrator will apply 1/12th of the personal allowance to the payment and 1/12th of each of the income tax bands to the extent that they apply.
£20,000 withdrawn, of which £5,000 (25%) is Tax-Free Lump Sum and £15,000 is income.
£ 987.50 (£11,850 / 12) taxed at 0% = £0
£ 2,875.00 (£34,500 / 12) taxed at 20% = £575
£ 9,625.00 (£115,500/12) taxed at 40% = £3,850
£1,512.50 taxed at 45% = £680
Total Tax Paid = £5,105
So, the £15,000 income has an effective tax rate of 34.03%.
Shortly after making the payment, the pension provider would normally receive an updated tax code from HMRC to use against any other income payments in the tax year and can usually help to address any overpaid tax.
However, this will not immediately recover any overpaid tax for clients who do not intend to take any more income during the tax year. Ordinarily, they would need to wait until the end of the tax year to claim back the over-paid tax.
On the other hand, it is also possible that income is paid from other sources that also use up the Personal Allowance or other income tax thresholds. In this scenario, using the emergency code will mean that more tax is due on the payment and this could increase the amount of tax deducted on future payments.
If there are no further income payments, any refund due can be claimed at the end of the tax-year, although this may require the completion of the self-assessment tax return. Alternatively, it is possible to submit an “in-year” claim from HMRC using the relevant claim form:-
- P50Z – For withdrawals that exhaust a pension fund and the client has no other sources of income.
- P53Z – For withdrawals that exhaust a pension fund and the client receives income from other sources.
- P55 – For use with a partial withdrawal of a pension fund and where there will be no further withdrawals in the current tax year.
One way to avoid such nasty tax surprises is to request the scheme administrator to make a nominal payment (up to £988 gross) prior to the main withdrawal. The small payment will be taxed on the emergency basis but will not attract any tax if below £988. The pension administrator’s provision of Real Time Information (RTI) PAYE data to HMRC usually triggers a revised tax code to be issued shortly after this payment and this code can be applied to future payments. This will avoid the need to apply the emergency code to the main withdrawal (although, please note, that the revised code could also be issued on a Month 1 basis).
The main point of note here is that, if a large withdrawal is required and it is intended to use the mechanism above to avoid a tax headache, more notice of intentions will be required.
Lump Sum vs Annual Payment
Where a one-off lump sum is taken, and the provider is not operating a Month 1 tax code, the Personal Allowance available to that point in the tax year can be applied to the extent it has not been used by earlier payments. If, however, the intention is to only take one payment during the tax-year, it can be requested as an annual payment. In this scenario, the whole personal allowance for the year can be applied, thus saving the need for any later reclaims.
I appreciate the above is a little complicated but if you are planning on making a withdrawal, please contact either myself or Adam and we will be happy to provide some guidance. Please do not be alarmed by any of this, it usually is a fairly straightforward process and with enough notice, it can be managed quite easily.
As always, if you have any concerns about your financial arrangements and whether you are truly making the most of your money, please do not hesitate to call me.
With kind regards,
Graham Ponting CFP Chartered MCSI