The emergency tax placed on pensions could soon be a thing of the past, removing the confusion around these deductions which can overshadow the need to plan withdrawals carefully.
The deduction of tax on an emergency basis when people take payments from flexi-access drawdown or via an uncrystallised funds pension lump sum, is one of the issues highlighted bt The Office of Tax Simplification.
Over the three years since pension freedoms were introduced, more than £300m has been refunded to clients by HM Revenue & Customs as too much tax had initially been deducted from them through the use of the emergency tax. The current system simply is not working.
As it stands, providers have to use a “month 1” emergency tax code when clients take payments from flexi-access drawdown or through UFPLS if they do not hold their current PAYE code – which, in the majority of cases, they will not have.
The month 1 basis means the tax is calculated using 1/12 of the personal allowance, regardless of the month it is paid. So, after the normal 25 per cent tax-free cash is taken, only £987.50 of the taxable payment is taxed at 0 per cent, rather than using the full personal allowance of £11,850.
The remaining amount is liable to tax using 1/12 of each of the tax bands – therefore the next £2,875 is taxed at 20 per cent, the following £9,625 at 40 per cent, with any remaining amount taxed at 45 per cent.
For example, an individual with no other income in the tax year who takes a £14,000 payment should pay no tax. The taxable payment (after tax-free cash of £3,500) is £10,500 which is within the personal allowance. But the emergency tax basis means a tax of £3,230 is deducted.
If the client is taking a regular income then the position will be resolved fairly quickly as HMRC will send the provider a PAYE code within a few weeks. This is used for future monthly payments and means the correct amount of tax is deducted over the tax year unless the client takes a large payment close to the end of the tax year.
The more significant problem arises when a one-off withdrawal is made. In this case, the emergency tax usually means too much tax is deducted – often significantly more. People then need to contact HMRC to reclaim the overpaid tax.
You can read the full article by Andrew Tully at Money Marketing