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Is this the answer to pension freedom withdrawal over-taxation?

HMRC-HM-Revenue-Customs-700x450.jpgThe solution to this widespread problem is sitting under HMRC’s nose

It is with keen interest I read the comments in the press about the unfairness of HM Revenue & Customs’ approach to taxing pension freedom payments under PAYE.

The problem is that it currently taxes such withdrawals on a month 1 basis, which assumes the same withdrawal will be made each month. This leads to consumers making a single withdrawal in a tax year being over taxed. It also amplifies any over- or under-payment of tax in other cases.

The situation has led one former pensions minister to call on HMRC to only levy basic-rate tax at the point of withdrawal then collect any extra due at the end of the year.

I will declare my biases up front: as a senior civil servant, I spent my time designing pension simplification and bringing PAYE into the 21st century, combining it with the benefit system. I therefore know a little about pensions and PAYE – probably enough to understand the pitfalls around this.

Steve Webb: Bizarre pension tax rules are costing freedoms savers

The trouble is there is not a simple solution. PAYE works best taxing regular payments. It copes with irregular payments but is predicated on the payer being in control.

Pension freedoms has turned some regular pension payments into a random single payment or a random series of payments all at the behest of the payee. It is this mismatch that causes the problem of what is the correct amount of tax to take off. That is the issue that faces HMRC.

To illustrate, let’s consider Tom. Tom wants £71,300 to pay off his mortgage. He knows he will pay tax and let’s assume he has got both a perfect adviser and a Tardis. So he can go to different universes.

Universe Withdrawal Tax on withdrawal Tax Adjustment Final tax
Current rules – assume paid monthly £127,166.70 £55,866.67 £-27,166.67 £28,700
Alternative 1 –  assume yearly paid £100,000 £28,700 0 £28,700
Alternative 2 – basic rate on everything £89,125 £17,825 £10,875 £28,700

In this example, treating the pension freedom payment as a single annual payment gets the right result, whereas taxing it at just the basic rate will lead to a surprising tax bill at the end of the year.

However, while this example works for those with no other sources of income or income that is not taxed under PAYE, it is not entirely typical. There are enough people like Harriet that HMRC has to take into account. She has a regular source of PAYE income and a pension she wants to access flexibly.

If we look at Harriet as being a basic rate payer with £20,000 of her basic rate band left, we find:

Universe Withdrawal Tax on withdrawal Tax Adjustment Final tax
Current rules – assume paid monthly £127,166.70 £55,866.67 £-19,866.67 £36,000
Alternative 1 -assume yearly paid £100,000 £28,700 £7,300 £36,000
Alternative 2 – basic rate on everything £89,125 £17,825 £18,175 £36,000

If Harriet was a non-taxpayer with £1,000 of personal allowance left, we would also get an imperfect solution under all three options.

The solution

The solution to this may lie with technology. Let us consider Richard, who is Harriet’s twin. HMRC is considering treating him as a test case.

It now has details of his regular pension reported on a payment-by-payment basis under PAYE. It has a new coding engine it is using to correct PAYE during the year, called Dynamic Coding.

When Richard’s flexibly accessed pension is reported on the day it is paid, HMRC put this into its coding engine. This works out whether Richard is likely to be under or overpaid and adjusts his tax code against his regular income.

Dynamic Coding has only been live since mid-2017 but it could help alleviate the problems if we changed the sequence so the amount of the pension freedom payment was sent to HMRC, and HMRC sent a code back that was then used to deduct the right tax in all cases.

This is how it feeds data to the Department for Work and Pensions for Universal Credit calculations. However, it would be novel for tax purposes and, as such, would need to be thought through, developed and tested, which may take a fair amount of time.

That said, people are currently being under taxed so there is an element of damage control required.

It is clear from the tables above that treating flexibly accessed payments as monthly payments maximises over payments and taxing everything at basic rate would lead to under payments in most cases.

Treating non-regular flexible access payments as annual payments would at least minimise under and overpayments. Most importantly, it would correctly tax those taking a single payment from a single scheme and would thus be a step in the right direction in the short term.

It seems logical that HMRC should allow payers to use practices that minimise the amount of wrong taxation while it sorts out a process that maximises correct taxation.

Yes, this is complicated. There is no magic bullet. However, almost three years into pension freedoms, and with a new tool in Dynamic Coding in place, now might be the time to look at this issue afresh.

Peter Hopkins is technical director at AJ Bell


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There are 3 comments at the moment, we would love to hear your opinion too.

  1. Not forgetting those making use of their 25% tax free element.

  2. I’m afraid that using ‘logical’ and ‘HMRC’ in the same sentence is a bridge too far.

    I have personally had nothing but problems with HMRC and so much so, that I now refuse to do anything electronically with Govt.

    I am sending in a paper SA form in 2018, having scanned it first, of course. The HMRC systems, processes and thoughts are not fit for purpose.

  3. The same happens with redundancy payments. A large lump sum taxed in month 1 as if it would be the same for the rest of the year with a large tax reclaim at the end of the year.

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