There has been much scratching of heads over the latest guidance from HMRC on how providers must deduct tax on ad hoc pension withdrawals from 6 April. It is fair to say it could be clearer.
Most will be aware pension withdrawals outside the element allowed as a tax-free lump sum (usually 25 per cent of the fund) suffer income tax in the usual way. Providers are expected to deduct tax in a way likely to exceed a person’s actual tax liability, leaving the person to claim it back from HMRC.
It is best to consider two types of people who might want an ad hoc lump sum.
Client A asks for a lump sum payment of £24,000 in April 2015. Unless the client has a P45 for the current tax year, the provider will tax the pension under emergency tax coding.
Thus 25 per cent (£6,000) will be treated as tax free and the remaining £18,000 taxed as though it is the first of 12 monthly payments of £18,000: ie. that client A has £216,000 of taxable income. The default will be to apply £10,600 personal allowance so the effective tax rate on the £18,000 will be 36.6 per cent or £6,592 calculated as follows: £31,785 at 20 per cent plus £107,615 at 40 per cent and £66,000 at 45 per cent = 36.6 per cent of £216,000.
This would need to be done whether the client only has £24,000 in total with one provider or more.
In the other scenario, Client B is taking £500 per month from a Sipp of £100,000. We have a tax code for these monthly deductions for the tax year 2015/16. If the client then wants an extra £24,000, we can treat the taxable element of that withdrawal without using emergency tax codes. Providers whose payroll systems do not have the functionality to process two payments in a month by applying the personal allowance in the tax code they hold to just the first payment and not the second will be obliged to treat the lump sum as above under emergency tax rules.
We would thus tax the £18,000 taxable element as though the total income was the £6,000 being received from us along with £18,000, so £24,000 in total as taxable income. Assuming client B has a tax code to apply £10,600 personal tax, we would deduct £2,680 income tax.
In both cases, if the client takes more pension withdrawals later in the year, HMRC will issue a new code to adjust future payments. How this will impact the client remains to be seen once the code is issued.
Clients wanting an ad hoc lump sum need to know they may face a high tax deduction. Client A may have to reclaim several thousands of pounds worth of income tax from HMRC or wait for it to re-pay automatically in the next tax year.
Alan Higham is retirement director at Fidelity Worldwide Investment