When the time comes to start accessing benefits from a pension for the first time, there are many considerations – and taxation of the payments should be one of them.
Understanding the process will avoid a nasty shock and enable the scheme member to get the best outcome. This isn’t an issue for defined benefit pension schemes or annuities: there aren’t the same options or issues associated with what is known as secured pension income, because it can’t be changed like income taken under the pension freedoms introduced in 2015.
Considerations
The first thing to consider is if there is any need to take taxable income from the fund: if there is a sufficient pension commencement lump sum – the tax-free amount – available to meet immediate needs, and as this is going to be a one-off payment, it may be worth considering not accessing taxable income at this time.
The implications of taking taxable income are more than just the tax paid, given the member would then be subject to a reduced annual allowance of £4,000, called the money purchase annual allowance. This isn’t an issue if the individual is truly retiring and will not want to make any future pension contributions, but more and more people remain in work or return to work after a break.
The second consideration if they do need to access taxable income is how this should be taken.
If an annuity has been discounted as an option, this leaves drawdown or an uncrystallised funds pension lump sum. For regular income, drawdown is likely to be the easiest and probably cheapest option. It will also usually mean less hassle with regards to taxation, as the taxation will sort itself out throughout the year and there will be no need to make any claims.
UFPLSs are usually used for single payments: they comprise 25 per cent tax-free and 75 per cent taxed income. As a one-off payment they can often result in the need to claim back tax paid, especially if the whole fund is taken as a single payment.
The biggest concern many people have is about the taxation of their pension payments. This should be a consideration, but ultimately the taxation will sort itself out one way or another, so no one will be out of pocket.
Emergency taxation
Emergency taxation will be applied when income or a lump sum is taken first. If regular income or lump sums plan to be taken, then the taxation will sort itself out over the remaining months in the tax year. This will usually result in an initial lower payment from the pension, but by the following month or so the extra tax paid will mean later payments within the year are higher to compensate.
The issues usually arise when single large lump sums are taken either under flexi-access drawdown or UFPLS. This is due to the tax code the scheme administrator must use and how it is applied.
In all cases for new income from a provider, the tax code will be used on a month one basis, even if the client has provided a P45 from the same tax year. The P45 will show their correct personal allowance, but the month one basis will still need to be used.
The month one basis means the income or lump sum can only utilise one 12th of the annual personal allowance, and one 12th of each tax band. The emergency tax code gives the individual a full personal allowance, even if it later turns out they are not entitled to one.
Take for example an individual with an emergency tax code and a taxable payment of £10,000 (see Table 1). It doesn’t matter what other income the client has for this first payment, or when in the year it is paid. The emergency tax code on a month one basis is the same.
Table 1: How emergency taxation works in practice
Calculation | £ |
Gross income payment | 10,000 |
Less 1/12 of full personal allowance | 987 |
Taxable income | 9,013 |
Tax | |
20% on £2,875 (1/12 of basic-rate band) | 575 |
40% on £6,138 (remainder in higher-rate band) | 2,455 |
Total tax payable | 3,030 |
Net income payment | 6,970 |
Source: HMRC. Copyright: Money Management
If the member was going to take £10,000 each month, had a full personal allowance, and this all started in April, then this tax would be correct. However, if the client has no other income, then this would be an overpayment of tax of £3,030, which would need to be claimed back. If the lump sum is bigger, it could fall into the 45 per cent tax bracket for some of the payment, which would mean even more tax would need to be reclaimed.
It should be noted that if the member is not entitled to any personal allowance, or is already a 45 per cent taxpayer, the tax paid would not be enough. In such cases, the member would either owe tax at the end of the year through their self-assessment, or have their tax code amended to collect the additional tax. They won’t just get away with it. The end result is the same for everyone: the correct tax will be paid.
Reclaiming overpaid tax
If the member doesn’t take regular income, then it may be worthwhile reclaiming the extra tax paid during the tax year. This is possible even if the funds within the scheme have not been exhausted.
Alternatively, if none of the forms are completed, HMRC will reconcile the tax paid at the end of the year, either during self-assessment if applicable or just under the usual PAYE process. It will then provide a refund or an amended tax code in the following tax year. This is the least hassle, but will mean a significant delay in the refund, or the tax rebate being spread throughout the next tax year.
Once the scheme has the correct tax code, the month one basis will cease, so following payments shouldn’t have the same issues and reclaims shouldn’t be required for income from the same scheme.
What is the impact?
In the first quarter of 2018, £29m of tax was refunded using 14,507 of the forms mentioned in Table 2. This may seem a large amount, but when you consider that in the same period £1.7bn of flexible payments were made from pensions to 500,000 pension members, it doesn’t seem quite as serious an issue.
Table 2: How members can claim a repayment of tax
Form name | Use |
P53 | If the member has taken a trivial commutation of a pension fund, or taken a small pension as a lump sum (not UFPLS). |
P53Z | If the member has flexibly accessed the pension pot, entirely emptied it and is working or receiving benefits. |
P55 | If the member has flexibly accessed the pension pot, but not emptied it. |
P50Z | If the member has flexibly accessed the pension pot, entirely emptied it and is not working or receiving job seeker’s allowance, taxable incapacity benefit, employment and support allowance or carer’s allowance. |
Source: HMRC. Copyright: Money Management
According to FCA retirement income data, 272,752 pension pots were accessed for the first time in the last quarter of 2017-18 (the most recent data available), which – if compared with the forms used in the first quarter of 2018-19 – means that just over 5 per cent of those who accessed their pots claimed. Ignoring annuity purchases, this would increase to nearly 6.1 per cent.
That said, for those members that are affected, the issue can cause significant cash flow problems if they are not aware of the process and implications.
Is emergency tax the right way to tax initial payments and lump sums?
Although it isn’t perfect, emergency tax does make sense regarding the pension freedoms. Prior to the introduction of flexi-access drawdown and UFPLSs, there was a requirement for an ongoing income. This would mean that even if the wrong tax code was used, HMRC would have somewhere to collect it from and a process to get the correct tax paid through the pension scheme.
Under the new rules, because pensions can be taken out in their entirety, should HMRC try to claim back underpaid tax on the funds taken, it would be much more time-consuming and impossible in some cases if the funds had been spent.
This all means that although it can be a hassle for some, HMRC isn’t losing out on tax due, making it fair for all those that do pay their taxes.
Claire Trott is head of pensions strategy at Technical Connection
