Beware of emergency tax codes on pension withdrawals

Over-55s planning to make an ad hoc withdrawal from their pension are being warned that they could be stung with an even heftier tax bill than they had expected.

Under current rules, the first 25% of so-called uncrystallised fund pension lump sum withdrawals are paid tax free and the remaining 75% is added to your income for the year and taxed at your marginal rate (the highest rate of income tax you pay).

However, as there is not enough information about the pension saver’s overall tax position, HMRC requires pension providers to apply an emergency ‘Month 1’ tax code. 

Emergency tax explained

This means you only get 1/12th of the available tax allowances – with HMRC assuming this is the first of a monthly series of withdrawals – and results in those savers making ad hoc withdrawals getting seriously over taxed. 

The rules could even see savers who don't expect to pay any tax at all being stung.

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According to AJ Bell, if a pension saver 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.  

Getting your money back

HMRC should refund the over paid tax, but with this process taking up to a year, savers are being advised to put a claim in for the money.

Since the pension freedoms were introduced in April 2015, HMRC says over 55s have reclaimed more than £600 million in overpaid tax and in the first quarter of 2020, it processed some 10,000 claims, with claimants getting an average refund of £3,141.

Tom Selby, senior analyst at the Sipp provider, says: “While the freedom and flexibility pensions now offer has been welcomed by millions, HMRC’s insistence on applying a ‘Month 1’ emergency tax code to the first withdrawal of the tax year has now seen savers reclaim £600 million in overpaid tax. 

“It’s worth remembering this only covers those who have made a reclaim using the official forms, and so doesn’t include any people refunded via HMRC’s systems at the end of the tax year.

“Anyone planning to access their pension in the new tax year – including those looking to use their retirement pot to plug an income gap resulting from COVID-19 – needs to be aware of the impact Month 1 taxation will have on the amount of money they receive initially.

“For those taking a regular stream of income, HMRC should automatically adjust your tax code so you receive the right amount in subsequent months. However, where you are making a single withdrawal in the tax year you will either have to fill out one of three forms or wait for the Revenue to sort out your tax position.”

How to claim back overtaxed pension

I you think you HMRC has charged you too much pensions tax, you will need to fill out one of the following three claims forms which can be found on the government’s claim a tax refund page.

P55

If you have not withdrawn your entire pension pot and are not taking out regular payments, you will need to fill out a P55 form.

HMRC received 6,286 of these claims from savers in the first quarter of 2020.

P53Z

A P53Z form should be filled out if you have withdrawn your entire pension pot and also receive other taxable income. A total of 2,973 claims were made in the first three months of this year.

P50Z

If you have drawn down your entire pension pot but have no other taxable income you will need to fill out the P50Z form.

This article was originally published on 10 April 2018 but has since been updated.