Don’t get caught in the pensions tax trap: Follow our smart tips to ensure you don’t lose half of your life savings
Pensioners who take large lump sums from their pension face a tax trap that could leave them having 45 per cent docked from their nest egg — even though they are basic rate taxpayers.
This is because of a quirk of the tax system which means that if you take £15,000 from your pot one month to last you through the year, you are likely to be taxed as though you were going to do this every month of the year.
In essence, this means that the taxman assumes you are going to take £180,000 from your pension in a year. As such, even if you have no other income, you’ll face a top rate of tax of 45 per cent.
But in reality you’d only have total income of about £23,000 including the state pension. You will get this tax back, but that means dealing with HM Revenue & Customs, which can be a complete nightmare.
This potential tax fiasco is one of the areas that threatens to throw the Pensions Revolution into utter confusion.
By being patient and taking your pension gradually over a few years, you could pay thousands of pounds less tax — and have that money to spend on yourself.
Danny Cox, a chartered financial planner at Hargreaves Lansdown, says: ‘With these new rules comes a great deal of personal responsibility. It is not simply a case of taking the money. People need to sit down and think through the consequences for their overall finances.’
The basic rule on tax is simple. You can take a quarter of your pension pot as a tax-free lump sum. The rest is taxable.
How the rules will work
Let’s take someone who retires next month, has £10,000 of pension savings and will receive the basic state pension.
They can take a quarter of their pension — so in this case, £2,500 — as a tax-free lump sum but the other £7,500 is taxable.
The basic state pension, which will be £6,030 a year from April, is taxable, so this will be added to their private pension to give taxable income of £13,530.
Their tax-free personal allowance of £10,600 will be deducted from this to give taxable income of £2,930. This will be taxed at 20 per cent, giving a tax bill of £586.
But they could avoid paying any tax at all if they took the pension income over two years.
So they could take £4,500 of their private pension this year and the other £3,000 next April. This would leave them with an extra £586 to spend as they wished.
Know the rules: The basic state pension, which will be £6,030 a year from April, is taxable, so this will be added to their private pension to give taxable income of £13,530
If they had £20,000 pension savings and took it all at once, they would receive £5,000 tax-free. But would have £10,430 of taxable income once their state pension was taken into account. This would leave them with a £2,086 tax bill.
But if they kept their taxable pension withdrawals to around £4,500 a year and spread them over four years, they could avoid paying all of this tax.
When doing these sums, bear in mind how your pension will work with savings interest.
If your total taxable income from all sources, including your savings, is less than £15,000 a year, you do not have to pay tax on your savings interest. So by spreading your pension withdrawals you may save yourself tax on savings interest as well as your pension.
Someone who is still working and earns £30,000 could also cut their tax bill by phasing their pension withdrawal.
If they took a £30,000 pension all at once they would have to pay £6,523 in tax. But if they withdrew the money over three years they could cut their tax bill to £4,500, leaving them with an extra £2,023 of spending money.
Here’s how it works. A quarter of the pension (£7,500) come as a tax-free lump sum, leaving £22,500.
If that were all taken at once it would be added to the £30,000 salary to make a total of £52,500 income for the tax year.
Your personal allowance is £10,600 and the basic rate tax band covers the next £31,785, but everything above £42,475 will be taxed at 40 per cent.
Details: Your personal allowance is £10,600 and the basic rate tax band covers the next £31,785, but everything above £42,475 will be taxed at 40 per cent
So although you are normally a basic rate taxpayer, £10,025 of your pension savings will be taxed at 40 per cent. Instead, you could still take the tax-free lump sum but then take the rest in even amounts of £11,250 over two years, making sure that you remain a basic rate taxpayer and in the process saving enough tax for a very nice holiday.
Higher earners and those with larger pensions could be caught in an even nastier trap.
If your taxable income exceeds £100,000, then your personal allowance is gradually stripped away. Someone who earns £50,000 a year and has £100,000 saved into a pension could take £25,000 tax-free. But the other £75,000 would be added to their salary to make a taxable income of £125,000.
This would mean that they lost all their personal allowance — so they would receive only £31,357 of their £75,000 taxable sum, with the other £43,643 disappearing in tax.
Instead, they could opt to take both the tax-free money and the taxable income annually.
Each year they could take £2,500 tax-free plus £7,500 in taxable income. This would give them a total of £7,000 a year after tax for ten years.
So in total they would get £70,000 out of their pension pot after tax, rather than the £56,357 they would get if they took it all at once.
And with a fair wind they would also enjoy some investment growth.
The tax trap on your income
As we have already mentioned a major thing to consider is how pension withdrawals will be taxed. Alan Higham, retirement director of Fidelity, says firms will have to use the emergency tax regime.
This means that when you make a withdrawal, the tax will be calculated as if you were taking that much every month — even if you are making a one-off withdrawal.
So in many cases too much tax will be taken initially.
You will then either have to fill in forms to claim a tax rebate or wait until the end of the tax year when HMRC does its own tax reconciliation. This should show that you have paid too much tax and trigger a rebate.
Taxing issues: As we have already mentioned a major thing to consider is how pension withdrawals will be taxed. Alan Higham, retirement director of Fidelity, says firms will have to use the emergency tax regime
Take the case of someone with a £24,000 pension pot. They could receive £6,000 tax-free. The other £18,000 would be taxed, and the pension firm would have to assume that they received this every month. The result, according to Mr Higham, is that they would lose £6,600 in tax rather than the £3,600 they would actually owe if they were a basic rate taxpayer.
They would eventually get the other £3,000 back from HMRC.
Elaine Clark, managing director of low-cost tax advisers Cheap Accounting, says: ‘The Revenue has a tendency to hang on to refunds and make people prove that they are owed the money — so the new pension rules are going to prove very problematic for many people.
‘The important principle should be: don’t just assume that because you are owed tax it will automatically find its way to you.
Help is at hand in the maze
Even if you have swotted up for hours on end, understanding tax can be, well, taxing.
For most of their working lives the vast majority of employees have their tax dealt with by the company they work for. It deducts their tax and hands it to the Revenue before it even hits their bank account. So to suddenly get to grips with different allowances is a whole new world.
Our table above should help you figure our some of the consequences of taking different amounts from your pension depending on what other income you have.
On top of this help should be at hand at every stage through the retirement process.
When you reach State Pension age there will be various tools at your disposal to help you avoid a tax headache.
First is the government’s Pension Wise service. This will offer all those about to take their pension a free advice session and is the perfect time to get all the information you need about how much tax you will have to pay, if you need to pay any, and how you do it.
Navigate your route: When you reach State Pension age there will be various tools at your disposal to help you avoid a tax headache
You should also be contacted by your pension provider with leaflets and a wake-up pack about the various options available to you at retirement and the tax implications of each.
If you want to double check your sums there are plenty of free tax calculators available online, or you could phone the tax man for help.
The crucial thing is that you don’t forget about tax when you’re making your retirement plans, or you could get a nasty shock when you take your pension cash.
Good financial advisers will also help run through the various implications of taking varying amounts from your pension pot.
Danny Cox, from investment firm Hargreaves Lansdown says: ‘Getting to grips with their tax is likely to be a significant new hurdle for many pensioners and it is vital that they think about all the consequences of taking different sums from their pot, before they withdraw it.’
Get a P45 and avoid that punishing emergency tax code
The surest way to avoid losing your nest-egg to an emergency tax code is to give your pension company a special form called a P45.
Your former employer must give you this when you leave your job on retirement. But to ward off the taxman it must be valid for the year in which you take your cash.
It will then be down to your pension company to work out how much tax you owe on withdrawals and pay it for you.
If you do not have a P45 and are hit with emergency tax rate on your pension withdrawals — don’t panic. You should be able to get the money back, although this may take time, patience and some form filling.
If you withdraw all the cash from your pension pot and have paid an emergency tax on it, you must fill in a form called a P50. You can find it on HMRC’s website gov.uk/claim-tax-refund/you-get-a-pension or order a copy by calling 0300 200 3300. HMRC should then refund any tax you are owed within a few weeks.
If you plan on taking cash from your pension in chunks, you would need to fill in a form called a P53. You can obtain a copy at the same website address and by using the same number.
If HMRC agrees you are owed a refund, any extra tax you have paid should be knocked off your tax bill on your next withdrawal. Again this should take only weeks to sort out.
If you are patient enough and don’t want the bother of filling in the forms, you can wait to the end of the tax year. Then anything you are owed should automatically be refunded by HMRC. But be aware that in reality this does not always happen. You may have to chase it.