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Steve Webb: Bizarre pension tax rules are costing freedoms savers

The tax treatment of lump-sum withdrawals means thousands are paying too much

Pension freedoms have been hugely popular. While few have blown their life savings on the mythical Italian sports car, many have enjoyed the ability to choose how much of their pension they want to spend now, how much to use to reduce debts or go on investing with, and how much to turn into a regular income.

But there is one aspect of the freedom and choice regime that still leaves a sour taste in the mouth: the tax treatment of lump-sum withdrawals.

Not unreasonably, income drawn from a defined contribution pension (in excess of any tax-free lump sum) is added to taxable income for the year in question. Large lump-sum withdrawals can therefore result in individuals moving into higher tax brackets, which provides an incentive to spread withdrawals over multiple tax years.

But those making even relatively small withdrawals can find themselves with surprisingly large tax bills they then have to claim back in whole or in part from HM Revenue & Customs.

This is because of the bizarre way in which HMRC has chosen to administer the taxation of such withdrawals. Under normal circumstances, pay-as-you-earn income tax works on a cumulative basis. This means people paying the right amount of tax each month, so that they have paid the right amount by the end of the year. However, pension lump sums over £10,000 are taxed on a non-cumulative or “Month 1” basis.

What this means is that, if the pension provider has no tax code to use (which most will not have), the saver is taxed as if they were going to make the same lump sum withdrawal every month.

Not surprisingly, this can mean that one month’s worth of an annual tax-free allowance of £11,500 is quickly exhausted and far more tax is deducted than is necessary.

Valuable research from AJ Bell has found that, while large numbers of people are making lump sum withdrawals from their pensions, only relatively small numbers are going through the painful process of claiming back the overpaid tax.

As a result, thousands of people are almost certainly paying too much tax.  This is a significant problem if they want to use the lump sum for a particular purpose but find the after-tax figure they receive is much less than they expected.

“Relatively small numbers are going through the painful process of claiming back the overpaid tax.”

A simpler solution

So what should be done? The obvious answer is for HMRC to stop using the Month 1 approach and instead simply deduct basic rate tax (at 20 per cent) from all taxable lump-sum pension withdrawals.

Most pensioners pay tax at the basic rate in retirement, so deducting 20 per cent should be roughly the right answer for most modest withdrawals. These people would no longer need to be over-taxed and then have to make a reclaim from HMRC, which would be simpler and easier for all concerned.

For those making larger withdrawals or those who would in any case be higher rate taxpayers, additional tax will still be due. But higher rate taxpayers generally fill in an annual tax return and they could declare their pension withdrawal through that. This would allow the extra tax due to be calculated and collected. For non taxpayers, it is true a 20 per cent withdrawal would still represent too much tax but there would be much less overpaid tax than under the current rules. They could still be actively encouraged to claim back any excess in the usual way.

The current tax treatment of lump- sum withdrawals from pensions is indefensible. Relying on individuals to understand the subtleties of cumulative and non-cumulative taxation, and then to claim back overpaid tax is a nonsense.

HMRC should be aiming – by default – to take roughly the right amount of tax from most people from the start, and then have a simple system to adjust the figure for those on the highest or lowest incomes. Now that pension freedoms have been up and running for two years, it is time this injustice was addressed.

Steve Webb is director of policy at Royal London



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There are 13 comments at the moment, we would love to hear your opinion too.

  1. Patrick Schan 3rd May 2017 at 1:26 pm

    Absolutely agree.

  2. Yes it’s a pain and seemingly unnecessary, but hardly ‘bizarre’ as this method of taxation has existed in differing degrees within the life and pensions industry for some years and outside of it as well. I would suggest that maybe the last minister may have done more to address this anomaly rather than ‘lobbying’ other issues (not you Steve btw). All a bit of a mess but not one that was unforeseen by those of us at the coal face (again!).

  3. Oh dear. Steve i think you have proved once and for all you know nothing about pensions – they aren’t simple and clearly nothing about tax – it isn’t simple.

    Just so I can get a handle on one point of what you are saying, why exactly is the current tax treatment of pension withdrawals indefensible?

    Maybe it is all to do with politicians making decisions about things they have absolutely no idea about and then moaning when people, who actually have experience and knowledge, explain in quite simple language that this is a bad idea. But then again, when did a politician ever admit to having a bad idea.

  4. Sorry Steve , i think HMRC have got it right .
    Imagine the trouble HMRC would have getting the additional tax back if everyone was taxed just 20%

  5. the process to reclaim the over paid tax is pretty simple if done on-line. Money is back in clients account within 2 weeks

  6. There is nothing Bizarre about the CONservative PArty Ponzi scheme against pensioners raising their tax thresholds to reclaim How much Mr Webb ? under your watch ? Pension Freedoms are only freedom to steal back Tax form those who saved for their retirement. Consumers cannot Trust the Parliament – and should certainly NOT save for retirement now.

  7. David Bettley 3rd May 2017 at 5:52 pm

    Why criticise HMRC for an efficient tax collection process. As a UK tax payer I applaud that they have collected the tax before it has been spent and is potentially irrecoverable. There is a very efficient process to refund which is a lot cheaper to administer then an expensive collection process.

  8. Surely the “right” method would be to get the correct tax code from hmrc before the lump sum was paid and apply it?. Unfortunately even when the client has his tax code companies still won’t accept it. In this day and age how hard should it be to get the correct tax code.

  9. I have a client with a tax code of 412L in tax year 2016/17. FAD had first been applied in the 15/16 year and the client was given a tax code. A further drawdown was taxed correctly. But in 16/17 the client was taxed on a month 1 basis even though he had a tax code. When I queried this with his SIPP provider I was told HMRC wanted the withdrawal to come under the month 1 regime. He is a pensioner in receipt of state pension of £6,880 in 16/17. He drew £18,135 gross from his SIPP and was taxed £6,847. We have to complete a complicated P55 form for this client. His tax should have been £2,803. A pensioner being charged excess income tax of £4,044. It is outrageous! Steve Webb is right, there must be thousands being overcharged income tax without the knowledge of how to get it back.

  10. Even where a paper form is used, it’s not the most complicated or time consuming effort and where involved, we would deal with the tax reclaim on behalf of the client.

    I also feel that it’s in everyone’s best interest to ensure those making a withdrawal aren’t under taxed in the first instance otherwise that could cause issues later down the line.

  11. Of course its (as always) an over complex system and if too much tax is being collected then its hardly the best way for Govt (via HMRC) to be serving the public (the purpose of Govt after all).
    But at least one side effect is that the size of the initial tax deduction can give pause for thought to those who might not by then have thought enough…

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