Dealing with an emergency situation

By September 1, 2022Pensions
Graphic of a hand reaching out of the word tax with another hand passing a buoyancy aid to it - Tax treatment of pension withdrawals

The pension freedom rules introduced in 2015 have been an undoubted success, allowing individuals to access their pensions in a far more flexible manner than ever before. However, drawing taxable income for the first time, or taking an ad-hoc single payment of income, from a plan held in Drawdown, can create a tax issue where H M Revenue & Customs deduct more Income Tax from the payment than is due, leading to a lower net payment than expected. For the unsuspecting pension holder, this can lead to complications, in particular if a net amount of funds withdrawn from a pension is needed for a specific purpose.


Holding the right Code

Unless the Pension provider holds an up to date Tax Code for the individual, the provider will need to tax the payment under a temporary Tax Code, which is known as an Emergency Tax Code. Under this Code, the amount being withdrawn is treated as if it will continue to be paid at the same amount each month, even if this is not the case. The provider will therefore apply 1/12th of the personal allowance (£12,570 in the current Tax Year) to the payment, and will assess the remaining payment against 1/12th of each of the income tax bands currently in force (i.e. Basic Rate at 20%, Higher Rate at 40% and Additional Rate at 45%).

For many this calculation will lead to an overpayment of Tax. Take the example of an individual who withdraws £20,000 from an uncrystallised pension as a lump sum. Their only other income is their State Pension of £12,570, which conveniently matches their Personal Allowance. The first £5,000 of the pension payment will be paid Tax Free (as this represents the 25% Tax Free Cash available on the amount crystallised) and the remainder of the payment should be taxed at Basic Rate Tax (i.e. 20%) which would lead to a total net payment after Tax of £17,000.

Instead of paying £3,000 in Income Tax, if the payment was taxed under an Emergency Tax Code, this could lead to a Tax charge of £5,025, resulting in a net payment after Income Tax of £14,975 – some £2,025 lower than if the correct amount of Income Tax had been deducted.


Doing the maths

It is important to point out that a refund of overpaid Tax is normally automatically paid at the end of the Tax Year. However, if you are seeking to withdraw a fixed amount from a Drawdown pension for a certain purpose, if Emergency Tax is applied then the net result could leave the withdrawal short of the amount required.

When considering a withdrawal from a pension, it is therefore important to consider the tax implications of how the payment is to be treated. You can contact the Pension provider in advance and check the Tax Code that the provider holds for you prior to making a decision to withdraw, although it is important to note that the provider has no discretion as to which Code to apply and must use the Code supplied by H M Revenue & Customs.

An alternative is to withdraw a smaller amount from the pension first, upon which the Emergency Tax Code is applied, and then withdraw the remainder of the required amount once H M Revenue & Customs have supplied a new correct Tax Code, which will be triggered by the smaller pension payment. Whilst this is a sensible step in theory, there will inevitably be a delay until the new Code is issued, which may not be practical if funds are needed in the near future.

If a payment has been made with Emergency Tax Code applying, it can be a good idea to claim funds back quickly following the payment. If the pension withdrawal is made in April or May, for example, not taking any action to reclaim the overpayment of Tax could lead to a wait of 11 months or more for a refund. Conversely, taking a pension withdrawal for the first time, or a lump sum, in March, would normally mean a refund of overpaid Tax would arrive in a matter of weeks.


Claiming a refund

Given the number of individuals falling into the Emergency Tax trap, H M Revenue & Customs have a rapid refund system, which aims to pay back the overpayment quickly once the correct form has been submitted. These forms are relatively simple to complete and whilst the forms are an additional step that requires action on the part of the taxpayer, this process does at least provide the opportunity to make a claim for the overpayment of Tax quickly.


Let us guide you through the process

The complexities of the Tax treatment of pension withdrawals is one of a number of reasons why sound independent advice can add value for those using a drawdown pension to help fund their retirement. The pension freedoms have provided greater flexibility but also increased the responsibility of individuals to manage their accumulated pension savings appropriately and to their best advantage for the long term.

At FAS, we can provide impartial advice to those considering retirement, or reaching retirement age, on the benefits and drawbacks of a Drawdown approach, and on other options such as annuities. For those already holding a pension in Drawdown, we can review the overall strategy and investment options with the aim of managing the withdrawals effectively throughout retirement.


If you would like to discuss your requirements further then speak to one of our advisers here.

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