In the age of the pension freedoms, many people are overpaying income tax on pension funds they have accessed.
In the last quarter of 2017, more than £20.5 million was repaid to pension members in excess income tax. These members completed almost 10,000 forms. And this does not even take into account those who have not claimed and will receive an automatic refund in the next tax year.
This is not tax efficient. We need to be advising and educating members on the best way to avoid having to reclaim tax that is not due on income payments.
In case of emergency
Before the introduction of the freedoms, income was usually taxed using a basic rate or higher rate assumption made by the provider. It was not a big deal if this was incorrect because it was not possible to take the whole fund and disappear off HM Revenue & Customs’ (HMRC) radar.
Nowadays this is not the case. If the provider does not have a valid tax code the member will be subject to emergency tax, on a ‘month one’ basis.
To the uninitiated, an emergency tax sounds horrendous. It sounds as though you are going to lose your whole fund to the government in one fell swoop. But this is not the case. I can vouch for this. The last time I changed jobs, HMRC decided I should be subject to an emergency tax code for a good few months until I challenged them on it.
What was different for me was that I was salaried and so it made very little difference. I got 1/12 of a standard personal allowance each month and 1/12 of each tax band to use, regardless of what had happened before in the year. It sorted itself out eventually and all was well.
But this is more of an issue for those taking out a single large lump sum. With only 1/12 of each band available, a significant amount of a lump sum payment could be taxed at 40% or even 45% up front. It really should not be once the whole year’s income is taken into account. This can be frustrating.
What, then, are the alternatives? Money could be paid out of pension schemes without collecting enough tax. But imagine the uproar when the lovely elderly couple down the road are hit with a large tax bill at the end of the year.
There would be even greater uproar if a large pension fund was extracted and disappeared, along with the member, so the tax due was never able to be recovered.
The simplest thing to do is to take regular income, rather than one-off lump sums. This would mean the income tax due would balance out during the year and the appropriate tax code would eventually be applied once received by the provider. There would be no need to claim the excess back and all would be well.
If you have to take a lump sum as the first and only payment in the year, unfortunately there is little that can be done. The best step would be to swiftly complete the appropriate forms to claim back the excess tax, minimising the time the tax man has the money.
If possible, paying then reclaiming income tax on flexibly accessed pension funds should be avoided. Educating those expecting higher initial payments will, at the very least, make clear the implication and reasons for the upfront taxation of payments.
Claire Trott is head of pensions strategy at Technical Connection