Tax trap for pension lump sums
If you are 55 or over with a money purchase pension fund then you can’t have missed that from 6th April this year you can take your entire fund in cash – regardless of its value.
But should you?
Well that all depends. For many and for many reasons it may be tempting….but maybe not advisable.
As with most big decisions there’ll be many factors to take into account – and one of them has to be tax.
There is more than one way to take benefits from your pension fund but if you take all or a chunk of your pension fund in cash (known as an “uncrystallised funds pension lump sum” – UFPLS) then 25% of it will be tax free. The remainder will be taxable as income in the tax year you take it.
So if you take £60,000 from your fund as a UFPLS, £15,000 will be tax free and £45,000 will be taxable. Basically, the taxable part will be added to your other income in the tax year you take it to determine how much tax is payable. As a reminder, the first £10,600 of your income (in most cases) is tax-free as your personal allowance is tax free. The next £31,785 is taxed at 20% and taxable income between £31,785 and £150,000 is taxed at 40% .Anything over £150,000 is taxed at 45%.
Given all of this, you can easily see how substantial pension lump sums could be taxed at rates of 40% or even 45%.
Say if the £45,000 I refer to above sat on top of other taxable income of around £50,000, £18,000 would be lost in tax leaving a net £27,000.
But the immediate position, when you receive the benefit, could be worse. Why is this? Well because of the way the tax system operates in relation to “one-off payments”.
The payer, (the pension company), has to deduct tax on the payment it makes under the PAYE system. But it won’t know exactly how much tax to deduct because the payment will be made during a tax year and they won’t know what your other income for the tax year will be. So what happens?
Well, it all depends on your circumstances. Unless you have a P45 from a previous source of income or employment that you received in the tax year in which you received the payment from your pension, then the pension company needs to operate the “Emergency code” on a so called “Month 1” basis.
Your personal allowance (and the “Emergency” basis) for the 2015/16 year is £10,600. This will be divided into 12 to determine your “tax free” pay for the month – just over £833. The crazy thing is, unless you can present the pension company with a P45 for the year of payment, in order to decide the rate of tax to apply to the payment, they have to assume that the amount of the payment you actually receive will be received for every month of the tax year. The rate deducted could thus easily be at 40% or even 45%. The amount of tax you should actually pay may well only be at 20%.
Let’s look at an example
Say you received £24,000 from your pension fund in April and expected to have enough other income in the year to use up your tax free personal allowance of £10,600. The £18,000 taxable part (£6,000 would be tax free) of your lump sum should only bear tax at basic rate – 20%. But on the presumption that you would receive £216,000 in the year (12 x £18,000) the average rate of tax deducted will be around 36.4%. So over £6,500 will be deducted from the £18,000 instead of about £3,600. So when added to your tax free cash you receive about £17,400. You should receive about £20,400. So you’ll be owed £3,000 from HMRC. The numbers depend on your circumstances but many will have tax “over deducted”.
How can you claim it back?
Well, it all depends on the circumstances.
There are three main forms to use to get your over deducted tax back without having to wait until the end of the tax year.
If you took your entire pension fund and have no other income in the year you need form
If you took your whole pension but have some other taxable income eg from work or benefits, you need form
If you have taken cash from your pension fund but not withdrawn the entire amount and are not making any other withdrawals in the same tax year then you need form
In situations 1 and 2 the pension provider is likely to provide you with a form P45 to help with the claim.
The forms can be accessed on-line or at the Post Office and it is estimated that refunds will take up to 30 days.
If your circumstances don’t match one of 1-3 above then it seems that you will have to wait until the end of the tax year to tidy up your affairs and get any tax back through the self-assessment system. HMRC will usually work out the over payment and repay it automatically.
A final thought
Finally, it’s worth noting that once you have taken more than just tax free cash from a pension fund you need to tell the providers of any other pension funds you are paying into as your annual contribution maximum will then fall from £40,000 to £10,000.
It’s a complicated situation, so if you would like advice on your specific circumstances, please get in touch.