Savers caught out as tax hits pension withdrawals

You can avoid the emergency code and get the right amount taken from your withdrawal if you have a P45 form that your pension provider can use. Picture: Getty
You can avoid the emergency code and get the right amount taken from your withdrawal if you have a P45 form that your pension provider can use. Picture: Getty
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Deduction by HMRC from cash taken in lump sums leaves many people with drastic shortfall in expected payout, writes Jeff Salway

AN HM Revenue & Customs rule that has left people overpaying thousands of pounds in tax on pension cash withdrawals will remain unchanged despite it causing chaos in recent weeks, it has been confirmed.

‘Some people are having to wait up to six weeks to get their money back’

Pension providers and advisers are reporting widespread confusion as savers discover that they have to make a claim for tax they’ve overpaid on ad hoc withdrawals.

The problem is one of several to arise from reforms that took effect last month allowing members of defined contribution (DC) schemes to take their pension pots in one go, with no obligation to use their liberated cash for a retirement income.

Savers can take up to 25 per cent of their pension pot tax-free – as before – and the remainder is charged at their marginal rate (rather than the previous 55 per cent).

Research suggests many people are unaware of the often significant tax consequences of taking lump sums from their pensions. But in the early weeks of the new regime it’s one of the lesser known tax rules that’s causing headaches.

The issue surrounds tax code “1000L M1”, the emergency rate being applied to ad hoc lump sums taken out of pension pots. The M1 stands for Month One, because HMRC assumes that if someone is taking cash from a pension scheme they’ll continue doing so each month.

So the cash taken in lump sums is being taxed as if the same amounts will continue being taken over a longer period. This approach is typically used for flexible drawdown, where regular payments are taken and HMRC corrects any overpayments in the following month’s payment.

Because they can’t do that if it’s a one-off payment, people taking single lump sums have to claim for typically thousands of pounds in tax overpayments that can take several weeks for HMRC to repay.

Iain Wishart, owner of Edinburgh-based Wishart Wealth Management, said: “Individuals who lose out either have to wait for HMRC to repay the excess tax charged – which could be many months later – or fill out an HMRC repayment form.”

The code often results in people being pushed into a higher rate tax band, he pointed out. While 25 per cent of pension income is still tax free, the emergency tax code is applied to the remainder.

“For many it means being charged 40 per cent tax rather than the 20 per cent they assumed they would pay. Those needing the cash for a specific purpose – such as paying off a mortgage – will find they don’t have enough money.”

For example, say you take £24,000 from your pension. Even with other income factored in you’re still below the 40 per cent tax threshold (which starts at £42,385). HMRC would normally take £3,600 from that withdrawal (assuming the 25 per cent tax-free lump sum is taken too), but the emergency tax code hikes that to £6,750 – an overpayment of almost £3,000.

Jamie Jenkins, Standard Life’s head of pensions strategy, said: “The tax position on ad hoc withdrawals from pensions is a key area of discussion with customers looking to take some or all of their pension pot. We are keen to work with HMRC and others in the industry to improve this process for customers.”

You can avoid the emergency code and get the right amount taken from your withdrawal if you have a P45 form that your pension provider can use. The majority of people will need to reclaim it or wait for a refund, however.

To reclaim the overpayment you can complete HMRC form P50 (if your state pension is your only other income source) or P53 (if you have other income).

HMRC should refund any overpaid tax within 30 days, either by issuing an updated code on the next pension withdrawal or through a direct repayment if the full pension was taken in one go.

A HMRC spokesperson said: “Claimants presenting their 2015/16 P45 to their pension provider will pay the correct tax. In the event that they don’t, any discrepancy will be settled within 30 days of HMRC being notified.”

Advisers are reporting that some people have to wait up to six weeks to get their money back, however.

The difficulty for many is exacerbated by the fact that the tax is taken before the payment, which means they get less than they expect from their pension withdrawal.

“It’s important people understand that if they’re taking a lump sum, the chances are they won’t receive the full amount they’re due initially because of the way tax codes work,” said Kate Smith, regulatory strategy manager at Edinburgh-based Aegon.

“In most cases people will pay an emergency tax rate on the payment and then they have the option to reclaim the overpaid tax immediately from HMRC, or wait until HMRC makes the tax adjustment in the following April.”

She urged those taking withdrawals to pay the additional tax upfront and reclaim it straight away rather than spend the money and wait for a tax bill.

The emergency code may have caused difficulties, but HMRC insists that because it’s part of PAYE rules going back to the 1940s there no scope for change.