Have you taken money out of your pension? If so, it’s important to check that you haven’t paid more tax than you need to and take action to reclaim your cash. One of the biggest attractions of the pensions freedoms is the ability to make lump sum withdrawals once you turn 55. You can use this money as you wish, whether you plan to blow it on a cruise, pay off your mortgage, invest it in a new business or simply help out your family.
However, the taxation of such withdrawals (snappily entitled uncrystalised pension fund lump sums or UPFLS), which are made before you start taking regular income from your pot or buy an annuity, is far from straightforward.
Although no tax is payable on the first 25% of any withdrawal (because you can take 25% of your savings tax free), the remaining 75% will be added to your income for the year and taxed at your marginal rate, that is the highest rate of tax that you pay. If your withdrawal is large, it may even be enough to put you into a higher-rate tax bracket.
For many over 55s – particularly those who pay the higher rate of tax – this is enough to put them off accessing their pension before they retire. However, for those who do proceed there is a further sting in the tail and that is the application of emergency tax.
What is emergency tax?
Emergency tax is applied when HMRC doesn’t have enough information about your income to use an accurate tax code and it will usually be applied until it has up to date details.
You might have previously paid emergency tax when you started your first job, got a company car or re-entered PAYE after a period of self-employment.
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It is also highly likely to be charged when you make your first withdrawal from your pension because your pension provider will not have an up-to-date tax code for you.
“The reason the government has to apply emergency tax is because when people come to take money out of their pension, their provider has no means of knowing what their income for the year is,” explains Richard Parkin, head of pensions policy at Fidelity International.
In such cases, emergency tax is charged on what is known as a ‘month 1 basis’. This means that even though your withdrawal is highly likely to be a one-off, it will be treated by HMRC as if it is the first of a series of monthly withdrawals and taxed as such. The tax you end up paying is therefore based on you withdrawing more than may actually be the case.
Self-invested personal pension (Sipp) provider AJ Bell gives the example of an investor who – trying to keep their withdrawal under this tax year’s £11,500 personal allowance – takes a lump sum of £10,000 out of their pension. Although our investor might believe no tax will be payable, they could end up paying as much as £3,099 in tax and getting a payout of just £6,901.
This is because the withdrawal would be regarded by HMRC as being the first of 12 monthly withdrawals and taxed on the assumption that you will take out £120,000 over that year.
This means that if there is a specific sum you need to raise from your pension, you may need to make a greater withdrawal than you planned to cover the cost of emergency tax.
How can I get my money back?
The good news is that if the application of emergency tax means you do end up over paying tax, you are entitled to get your money back. The bad news is that if you want to get your hands on it anytime soon, you’ll have to be proactive and apply for a refund.
Guidance from HMRC says that if people don’t apply for refunds, it “will reconcile their account and make any repayment owed as part of its normal PAYE process”.
However, it is not yet proven how quick and efficient this process is – particularly for those who aren’t working, paying tax or completing an annual tax return. When Moneywise asked HMRC how long this process would take it was not able to give us an answer.
Tom Selby, senior analyst at AJ Bell, says: “Just trusting HMRC to sort it out at some unknown point in future is unlikely to be something most people are comfortable with – it’s their money.”
Mr Parkin adds: “You’ll get your money back much faster if you fi ll out the forms – so that’s what we always encourage our customers to do.”
You can download the necessary form from Gov.uk/claim-tax-refund/you-get-a-pension. But make sure you use the right form for your circumstances. Use form:
P50Z – if you have emptied your pension and have no other income in that tax year.
P53Z – if you have emptied your pension but have other taxable income.
P55 – if you haven’t used up your pension and you won’t be taking regular payments.
If you haven’t used up your pension but you do plan to take further regular payments, any mistake should quickly be corrected through PAYE.
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HMRC says that once it has received your completed forms, it will repay any money owed within 30 days.
Mr Selby adds: “How much you get back will depend on your income. It will be recalibrated to take the tax you should have paid into account.”
Can I avoid emergency tax?
HMRC confirmed that the best way to avoid paying emergency tax is to supply your pension provider with your P45.
Mr Parkin says: “If someone has their P45, we would, of course, urge them to provide us with it in order to prevent a costly emergency tax situation. However, there is an important thing to bear in mind: most people accessing their cash won’t have one as they haven’t stopped working and you only get a P45 when you leave your job. It’s therefore highly likely that most people won’t have anything current to provide, so it’s important that people know they could be incurring a tax bill and inform HMRC promptly.”
Yet while HMRC has processes in place to quickly refund victims of emergency tax, once they have been notified (with the aforementioned forms), many over 55s will understandably be frustrated that they have to shell out in the first place.
Mr Selby says: “A better method would be if HMRC just treated each individual withdrawal and tax it on a 12-month basis, that is as a single withdrawal and tax it accordingly.
“I’m not sure why HMRC is doing this – it feels so heavy handed, like people are punished for doing something they are being encouraged to do as part of the pension freedoms. It causes unnecessary pain and annoyance.”
Top Tip 1: A number of companies including Aviva, Hargreaves Lansdown, and Scottish Widows offer calculators on their websites that can give you an indication of the amount of emergency tax you’re likely to pay, based on the withdrawal you plan to make.
Top Tip 2: Check your tax code. If you think you have paid too much tax on a pension withdrawal, it’s worth checking the tax code on the paperwork you were sent when you received the money. If your withdrawal was taxed on a month 1 basis, you will see the code 1150L for the current tax year (2017/18). For the 2016/17 year, the code would have been 1100L and 1060L for the 2015/16 tax year.
“Tens of thousands of people will have paid too much tax”
AJ Bell reckons that tens of thousands of people who have accessed their pensions since the pension freedoms will have been stung by emergency tax, yet the latest data available suggests that few are actively reclaiming their cash.
Figures from the Financial Conduct Authority show that since April 2015, an average of 139,000 pensions have been accessed for the first time every quarter – the vast majority of which will have been taxed on the punitive ‘month 1’ basis. However, figures from HMRC show that during 2016, it only received an average of 10,998 claims for overpaid tax in each quarter.
Tom Selby, senior analyst at AJ Bell, says: “HMRC’s insistence that an emergency tax code must be applied to pension freedom withdrawals means tens of thousands of people will have paid too much tax on their withdrawals yet very few of them have reclaimed this tax. This might be because they don’t know they have paid too much tax or the process to reclaim it just seemed too complicated.‑Whatever the reason, there are likely to be millions of pounds sitting with HMRC that could be legitimately reclaimed.”