Over-55s planning to make an ad hoc withdrawal from their pension this year are being warned that they could be stung with an even heftier tax bill than they had expected.
Under current rules, the first 25% of so-called uncrystallised fund pension lump sum withdrawals are paid tax free and the remaining 75% is added to your income for the year and taxed at your marginal rate.
Those making withdrawals from income drawdown plans should also be taxed at their marginal rate.
However, as there is not enough information about the pension saver’s overall tax position, HMRC requires pension providers to apply an emergency ‘Month 1’ tax code. As such you only get 1/12thof the available tax allowances – with HMRC assuming this is the first of a monthly series of withdrawals – which results in those savers making ad hoc withdrawals getting seriously over taxed.
According to AJ Bell, this could see an individual making a £2,000 withdrawal being overtaxed by more than £200, rising to over £3,000 on £10,000 withdrawal.
HMRC should refund the over paid tax, but with this process taking up to a year, savers are being advised to put a claim in for the money.
Tom Selby, senior analyst at the Sipp provider, says: “Tens of thousands of people using the pension freedoms every month risk falling into this tax trap. On average, the level of over-taxation runs into thousands of pounds and for some it could be tens of thousands of pounds.
“The problem is at its most acute at the beginning of the tax year as anyone who makes an ad-hoc withdrawal and doesn’t fill out the right form to claim the money back will have to wait until at least April 2019 to get their money back. Even then, you are relying on the efficiency of HMRC to put you back in the position you should have been in in the first place.
According to HMRC, close to 140,000 over-55s dip into their pension for the first time every quarter and the vast majority of these are likely to have been taxed at the emergency rate. Yet despite this, it is only processing an average of 10,500 claim forms each quarter, suggesting that most people are either unaware that they have been overtaxed or are relying on HMRC to fix it.
Mr Selby adds: “Savers accessing their pensions for the first time using the freedoms understandably expect to receive the correct amount of money. Many will have specific plans for their withdrawal, such as to pay down debt or fund long-term care for an elderly relative. For people like this, getting thousands of pounds too little will present a serious financial challenge.
“HMRC should, at the very least, consult on its approach to single pension freedoms withdrawals and review the risks it poses to savers. Allowing providers to apply a ‘Month 12’ tax code would be a more consumer-focused solution, with HMRC taking responsibility for recouping any underpaid tax.”