How can paraplanners help clients avoid the heavy tax payments on money flexibly drawn from pensions? Joshua Croft, technical consultant at AJ Bell looks at the issue
Having passed the fifth anniversary of pension freedoms, most people would agree they have been well received with those aged 55 or over, as they now have much more flexibility when taking pension income and lump sums.
Furthermore, withdrawals are not slowing down. In fact, HMRC’s statistics show that in Q1 2020 348,000 individuals flexibly accessed payments of almost £2.5 billion, an increase of 19% from the same period in 2019. Since pension freedoms were introduced in 2015 over £35 billion has been accessed.
It therefore becomes ever more important that clients understand how the taxation of these payments works, as it can lead to confusion and unexpected outcomes.
Emergency tax code
With pension income, scheme administrators must deduct income tax at source as per the HMRC PAYE system. This can sometimes lead to over-taxation as until the scheme administrator has the current year tax code for the member, they have to under the rules use an emergency tax code.
For those taking a regular stream of income, HMRC should automatically adjust their tax code so they receive the right amount in subsequent months. But where a client is making a single withdrawal in the tax year the system is likely to lead to an overpayment of tax.
The emergency tax code is on a ‘month 1’ basis meaning that if a client takes an income payment at the begin of a new tax year, which is the most popular time, they will only receive one twelfth of their personal allowance, leading to a much higher amount of tax deducted than they would be expecting.
For example, if someone makes a pension withdrawal of £12,500 (the same level as the personal allowance) and has no other taxable income, they might expect to be taxed at 0%.
However, because Month 1 is applied all their usual tax allowances are divided by 12. This means only £1,042 of the withdrawal is taxed at 0% (1/12th of £12,500), with the next £3,125 taxed at 20% (1/12th of £37,500). The remaining part of the withdrawal is taxed at 40%, giving a total tax bill of almost £4,000.
There have previously been calls for change, with the Office of Tax Simplification calling for a review because the current system is “not easily understood”. In reply, HMRC confirmed that they would not be changing the system and that “the existing PAYE treatment of flexible drawdown pension drawdowns remains the most effective method of deducting tax in these cases, and it reduces the risk of underpayments of tax arising”.
Reclaiming the tax
In the absence of any changes to the current system what can clients do to reclaim their overpaid tax or try to avoid the overpayment in the first place?
If the client takes no action after being over-taxed HMRC will in most cases automatically correct the position at the end of the tax year as part of the normal PAYE process by sending a P800 tax calculation and refunding any over payments. If this doesn’t happen, they will need to contact HMRC or complete a self-assessment return.
There is also a process to reclaim any overpayment within the tax year, by completing and submitting one of the following forms to HMRC: P55, P50Z or P53Z. The form required depends on the client’s specific circumstances;
P50Z – If the payment used up their pension fund and they have no other income in the tax year
P53Z – If the payment used up their pension fund and they do have other taxable income
P55 – If they have withdrawn only part of their fund and they are not taking regular payments
These forms can be completed online and HMRC quote a 30-day turnaround to pay tax refunds.
Prevention better than cure
Another option is for the client to withdraw a small initial income payment. This will prompt HMRC to provide a correct tax code for the scheme administrator to use going forward. The initial payment will be overtaxed, but any subsequent income payments will be taxed appropriately rather than on a Month 1 basis.
This requires some forward planning but for clients looking to take larger one-off lump sums from their pension funds, it is worth considering. Not only will it avoid a large (if temporary) overpayment of tax, it means more funds can remain in the tax-free environment of the pension.
