The horrifying pensions tax trap - and how to avoid it

Pension tax shockPeople 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.

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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it would be treated as the first of twelve £10,000 withdrawals and tax would be calculated based on £120,000 being withdrawn throughout the year.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.

Money back

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 loophole

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.

How we spend our pensions
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How we spend our pensions

Figures from Saga show that the over 50s now account for the majority of money spent by Brits on travel and tourism. They have the time to spare, the money, and they are healthy enough to take on the world.

A poll from Abta found that in the wake of pension freedoms, 35% of people were considering cashing in at least part of their pension to travel. A separate study by Senior Railcard found that pensioners take an average of three holidays a year, plus two weekends away, and 17 day trips.

Research from Senior Railcard found that retirees eat out an average of three times a month. However, one in ten do so more than twice a week, and one in three people said that one of the first things they did when they retired was to go out for lunch with their friends.

Of course, just because retirees want to enjoy themselves, it doesn't mean they are happy to throw money away. The vast majority are keen to eat at lunchtimes, when a fixed lunch menu tends to be cheaper, and canny retirees are skilled at tracking down pensioner special offers too.

Figures from the Office for National Statistics show that on average nearly a fifth of the money spent by people aged 65-74 is on leisure. This includes everything from the cinema and theatre to golfing and gardening. They spent more on this than on food, energy bills and transport.

A report by Canada Life found that retirees are spending £4,279 a year on having fun - that’s more than £1,000 more than they spend on boring essentials, and is a 74% increase over the past ten years. It went on to predict that this trend was set to continue, and that pension freedoms would encourage people to spoil themselves a bit more in retirement

Pensioner property wealth is now over £850 billion, and all these family homes don’t look after themselves. The Senior Railcard survey put home renovations in the top 20 activities people got stuck into on retirement, and figures from ABTA found that almost a third of people who were considering raiding their pension pots under the new pension freedoms planned to spend the cash on their home. This seems like an eminently sensible investment - looking after what is undoubtedly their most valuable asset.

Unsurprisingly, while some pensioners are very well off indeed, others are struggling with debt. Figures from Key Retirement found that the average retiree has £34,000 of debt.

Most of this is mortgage borrowing - in many cases driven up by the number of people who unwittingly signed up to an interest-only mortgage. However, credit cards, overdrafts, and loans are also common. It’s why so many pensioners have used pension freedoms to access enough cash to pay their debts.

The day to day basics are swallowing up their fair share of pensioner cash too. On average, people aged 65-74 spend a third of their weekly income on essentials like food and bills - which is hardly living the high life.
The bank of gran and grandad has become an increasingly vital source of cash for families. According to Key Retirement, of those who release equity from their property, 21% of them use the cash to treat their children and grandchildren. This includes an average of £33,350 to help children get onto the property ladder, £6,000 to buy them a new car, £11,000 on family weddings, and £24,780 giving grandchildren a helping hand.

While retirees are quite rightly spending what they need to enjoy retirement, they are hardly all throwing caution to the wind, buying flash cars and spending the kids' inheritance.

Most expect to have something left over to pass onto their family after their death. Some 69% expect to leave property in their wills, and 75% expect to leave cash - according to - because while baby boomers know how to have fun - they also know how to save for the future.


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