The horrifying pensions tax trap - and how to avoid it
People taking lump sums from their pension have been hit with huge pension tax bills out of the blue, after falling foul of a little-known rule. Fortunately, the pension boffins have come up with a cunning plan to avoid it.
SEE ALSO: The one move that will boost your pension income by two thirds
See also: Young people want to scrap pensions triple lock
Pension freedoms introduced in 2015 have allowed people to dip into their pension pot for lump sums - as and when they need it. The first 25% is tax-free, and then the rest is taxed at your marginal tax rate. Your 'marginal tax rate' depends on the amount of income you receive in that year.
In the current tax year, the first £11,500 is tax free. The rest (up to £45,000) is taxed at 20%, then between £45,000 and £150,000 is taxed at 40%, and anything over £150,000 is taxed at 45%. Technically, therefore, if you have no other income, you can withdraw up to £11,500 without paying any tax.
The problem, however, is that if HMRC hasn't received a current valid P45 - or your pension provider hasn't received confirmation of your personal tax code from HMRC - then when you take a lump sum, HMRC assumes you will take the same amount each month, and applies what's known as 'emergency tax'. This means that instead of having your full personal allowance, you will have just a 12th of it.
This could leave you overpaying tax by hundreds or even thousands of pounds. According to AJ Bell, someone withdrawing £10,000 from their pension deliberately to keep themselves under the personal allowance would have expected to pay no tax but in fact they may pay £3,099 in tax. This is because under a 'month 1 basis' it would be treated as the first of twelve £10,000 withdrawals and tax would be calculated based on £120,000 being withdrawn throughout the year.
Hargreaves Lansdown has a tax calculator that shows just what it will cost you through the emergency tax system.
You won't lose any money in the long run, because the extra tax will be refunded, but you will be worse off in the short term - which could be a problem if you have earmarked the entire lump sum for something specific - like debt repayment.
Those who have been over-taxed will then have to either wait for HMRC to put them on the correct tax code - which could take until the end of the tax year - or they can claim the tax back, which can take six weeks. Figures from the FCA would seem to indicate that most people are not reclaiming the money. An average of 139,000 pension pots per quarter are accessed for the first time - and most are likely to have been taxed using an emergency code. However, HMRC data for 2016 shows that on average only 10,998 reclaims for overpaid tax have been made per quarter.
Tom Selby, senior analyst at AJ Bell, comments: "HMRCs insistence that an emergency tax code must be applied to pension freedom withdrawals means tens of thousands of people will have paid too much tax on their withdrawals yet very few of them have reclaimed this tax. This might be because they don't know they have paid too much tax or the process to reclaim it just seemed too complicated. Whatever the reason, there is likely to be millions of pounds sat with HMRC that could be legitimately reclaimed. It is up to individuals to check whether they have paid too much tax and to make a claim, they are unlikely to get any help from the Government."
Reclaiming shouldn't be a major headache, but there is an alternative.
The experts have discovered that there's a way around this problem. Pensioners are being advised to consider starting by making a small withdrawal - possibly only of £1. HMRC will apply the emergency tax code to this, but the move will also alert HMRC to the need to apply the correct tax code, so that when you make your next withdrawal a few weeks later - of the sum you really want to take - you won't be over-taxed on it.
Of course, whether you take this approach will depend on your circumstances. In some cases, your other income will mean you still have to reclaim the tax. In others, the amount your provider charges for withdrawals will make this loophole prohibitively expensive. While some people will be in too much of a rush to get the money to go through this process first.
In some cases it makes sense to put up with the tax issue until you get a chance to reclaim the money. In other cases, the £1 loophole will save you an awful lot of time and hassle.
Either way, it's worth gaining an understanding of where you stand, and the most cost-effective approach in your circumstances - rather than facing a tax bill out of the blue.