In the past, many people with modest pension pots used their pension to buy an annuity to give them a guaranteed income for life. The annuity provided a regular income, perhaps a monthly payment, and this was taxed in the same way as a wage or other regular income.
But since the advent of ‘pension freedoms’, growing numbers are choosing to take their money out of the pension as a lump sum. This might be their choice if, for example, they have a state pension and perhaps a company pension to provide regular income, but they also want a capital sum, perhaps to pay off a debt or for a special item of expenditure.
Tax on a lump sum
The question then arises as to how much tax should be paid on that lump sum withdrawal? In theory, your lump sum is added to your total taxable income for the year in question and taxed accordingly.
In effect, this means that if you are already paying tax at the standard rate of 20 per cent, you may end up losing 20 per cent of your lump sum; if you are already paying at 40 per cent, you could lose 40 per cent and so forth.
Larger pension withdrawals can even move you into a higher tax band, so although you are a basic-rate taxpayer you use up your basic rate ‘band’ and the last slice of your pension is taxed at a higher rate. (This is one reason why taking out the cash in one big lump may not be such a good idea).
But what happens in practice can be much more severe than this. This is because HMRC makes the assumption that this withdrawal is not a one-off, but rather that you are probably going to do the same thing again the next month and the month after that. On that basis, it assumes that you will quickly use up your tax-free personal allowance and the 20 per cent standard rate tax band, and will end up well into the 40 per cent tax band over the year as a whole. This is sometimes called being taxed on an ‘emergency’ basis, and it results in a big overpayment of tax.
To give an example, suppose that you cash in a pension pot of £50,000, taking a quarter tax-free, and the remaining £37,500 as taxable withdrawal. If you take this as a lump sum at the start of the financial year you may find that HMRC deducts over £15,000 in tax. If you don’t have much other taxable income for the year, this could represent double the correct amount of tax.
Reclaim excess tax
Because HMRC realises this approach will result in lots of people being over-taxed, it has set up a system that allows you to reclaim excess tax. But the system is so complicated that there are three different forms to choose from, depending on the details of your situation.
This is little short of a scandal. HMRC is overtaxing people by around £100 million per year, which is money that it sits on until people claim it back or fill in their next tax return. To me, this feels like a case of ‘tax first, ask questions afterwards’. A much better system would be to simply deduct tax at the standard rate of 20 per cent from all lump sums, and then make any adjustments at the end of the year through the normal tax return process.
There is little you can do to challenge HMRC about this, but you need to be aware when planning a withdrawal that the tax taken out could initially be much higher than you thought. You also need to make sure you claim the tax back as soon as possible, rather than leaving it in HMRC’s bank account for the government to enjoy.
Steve Webb is director of policy at Royal London.
Keep up to date with all the latest personal finance news and investment tips by signing up to our newsletter. Email subscribers will also receive a free print copy of Money Observer magazine.
Subscribe to Money Observer Magazine
Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.Subscribe now