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Andrew Tully: End in sight for pensions emergency tax issue

It is good new options are being discussed, as confusion around these deductions can overshadow the need to plan withdrawals carefully

The Office of Tax Simplification recently published a review of the taxation of savings income. One of the issues highlighted was the widespread confusion caused by the deduction of tax on an emergency basis when people take payments from flexi-access drawdown or via an uncrystallised funds pension lump sum.

Over the three years since pension freedoms were introduced, more than £300m has been refunded to clients by HM Revenue & Customs as too much tax had initially been deducted from them through the use of the emergency tax. The current system simply is not working.

As it stands, providers have to use a “month 1” emergency tax code when clients take payments from flexi-access drawdown or through UFPLS if they do not hold their current PAYE code – which, in the majority of cases, they will not have.

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The month 1 basis means the tax is calculated using 1/12 of the personal allowance, regardless of the month it is paid. So, after the normal 25 per cent tax-free cash is taken, only £987.50 of the taxable payment is taxed at 0 per cent, rather than using the full personal allowance of £11,850.

The remaining amount is liable to tax using 1/12 of each of the tax bands – therefore the next £2,875 is taxed at 20 per cent, the following £9,625 at 40 per cent, with any remaining amount taxed at 45 per cent.

For example, an individual with no other income in the tax year who takes a £14,000 payment should pay no tax. The taxable payment (after tax-free cash of £3,500) is £10,500 which is within the personal allowance. But the emergency tax basis means tax of £3,230 is deducted.

If the client is taking a regular income then the position will be resolved fairly quickly as HMRC will send the provider a PAYE code within a few weeks. This is used for future monthly payments and means the correct amount of tax is deducted over the tax year, unless the client takes a large payment close to the end of the tax year.

Significant problem

The more significant problem arises when a one-off withdrawal is made. In this case, the emergency tax usually means too much tax is deducted – often significantly more. People then need to contact HMRC to reclaim the over-paid tax. This can be done either through the self-assessment system or by submitting a form to HMRC.

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To make matters more complex, there are three forms and the appropriate one to use depends on the client’s circumstances:

  • Form P55 is suitable for those who have made a partial withdrawal from their pension pot.
  • Form P50Z is for those who have withdrawn their entire pension pot and have no other income (including no taxable benefits).
  • Form P53Z is for those who have taken their full pension pot and
    are still receiving income from other sources.

If the correct form is used and submitted to HMRC it says the refund should be made within 30 days. If someone does not claim, then HMRC should proactively make a refund, although the timeline for this is less clear.

One option to ensure more accurate tax is levied on a payment is to withdraw a small payment initially. For example, if someone withdraws £100, that will be taxed on the emergency basis. This provokes HMRC to send the provider the appropriate tax code for the client, which should happen within a few weeks.

The full withdrawal can then be made, and the tax levied will be more accurate as the provider has the client’s tax code (although a small reclaim may still be necessary). This requires a little advance planning but gives a better client outcome.

Unintended consequences 

One of the unintended consequences of the use of the emergency tax basis is that it may encourage clients to take additional pension withdrawals. Someone who needs a certain amount of money may find they receive less than originally expected. Rather than wait for an HMRC refund, they may withdraw an additional sum from their pension.

What pension tax policymakers can learn from AE success

Our income tax system is designed to deduct tax from regular payments spread more or less equally over the tax year. As a result, whichever method is used to deduct tax from lump sum payments is likely to be wrong, meaning a refund will have to be made by HMRC or an underpayment settled by a client.

We run the risk that confusion around emergency tax deductions will overshadow the need to plan pension withdrawals carefully. The current system certainly means many clients have a poor experience when trying to withdraw their funds.

The OTS wants to explore alternative options with HMRC, which is the right course of action. The current system is skewed too far towards significantly over-taxing in the vast majority of cases and sorting this later, rather than attempting to deduct a more accurate amount in the first place.

Andrew Tully is pensions technical director at Retirement Advantage

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