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