A very taxing issue...

The Exchange


Andy Zanelli looks at pensions and taxation and how taking a lump sum can result in a large unexpected tax payment.

The information contained in this page is for professional Financial Adviser use only.


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):

 

Annual Tax Band

Month 1

Tax rate

Tax due

Personal allowance

Up to £11,500

£958.33

0%

0

The remaining income is then taxed at:

Basic rate band

£33,500

£2,791.67

20%

£558.33

Higher rate band

£33,500 - £150,000

£9,708.33

40%

£3,883.33

Additional rate

Over £150,000

£24,041.67

45%

£10,818.75

 

 

 

Total tax due

£15,260.42

 

 

 

Total taxable

£37,500.00

 

 

 

Net amount

£22,239.58

 

 

 

Plus PCLS

£12,500.00

 

 

 

Net paid

£34,739.58

As the example shows as soon as the taxable part of the withdrawal reaches £13,458.33 the client is paying 45% tax on all of the withdrawal above this level. For a basic rate taxpayer this can come as quite a shock!

If the client had no other income at all and this was the only payment they received in the tax year the actual tax bill would be £5,200 – a significantly lower figure than the £15,260.42 tax actually deducted from the income payment.

Clients will need to be aware of this if they are considering taking a lump sum payment from their pension savings as if they act without taking any advice, if the money is needed urgently for example, there can be an even more severe effect. I am aware of some providers who have asked the client the net amount they actually need and then have worked the figures back to see the gross withdrawal needed. If a tax rate of 45% is being applied to the majority of the withdrawal then a large sum is being removed from the tax efficient pension wrapper.

In time the client will get any overpaid tax back, either through PAYE if they are taking future payments or by submitting a claim to HMRC. The point is that this tax repayment is now not in a pension scheme. They may have scope to pay it back in, however the Money Purchase Annual Allowance will have been triggered and until the recent announcements in light of the June General Election this was due to reduce to £4,000. All in all a very taxing issue!

The information contained in this page is for professional Financial Adviser use only. If you are a private investor, please visit the Private Investor section or contact your Financial Adviser for more information.

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