Andy Zanelli looks at pensions and taxation and how taking a lump sum can result in a large unexpected tax payment.
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There is little doubt that pensions freedoms have delivered a greater choice for those looking to access their retirement savings – a fact borne out by the many statistics on the amount of funds accessed and the amount of tax HMRC have received as a result of this. There are complexities with both pensions and taxation and one particular issue causes a great deal of confusion. This is where a client wishes to take a lump sum from their pension savings which results in a large unexpected tax payment.
As financial planners we have always known that a pension is the replacement, in retirement, of employment income. This for me is the key point as any income from the pension scheme is taxed as earned income and is subject to Pay As You Earn (PAYE). This is the root of the confusion, the client may be thinking "lump sum" and that they have a personal allowance, basic rate tax band etc. but the payment is treated as income. This did not change as part of the pension freedoms.
When an income payment is made under PAYE the pension provider either has to have an up to date tax code for the client or apply the emergency rate basis – this was confirmed in Pension Schemes Newsletter 68. As the client is taking a lump sum this will be, in most cases, the first payment from the scheme. The client can provide a P45 from the current tax year or a tax code from a current pension plan. In most cases this doesn't happen.
So if this is the first withdrawal from the plan the pension provider will have to apply an emergency tax code which treats the payment as if it will be paid each month. This is known as the "Month 1" basis. In this case the pension provider will apply 1/12th of the current personal allowance (£11,500 in 2017/18), 1/12th of the basic rate band, 1/12th of the higher rate band and the balance will then be taxed at the additional rate of 45%. An example of how this would be applied may be useful here:
Example: Fund value £50,000 (£12,500 tax-free and £37,500 taxable):