Pension Schemes Newsletter 68 confirmed that unless a pension provider holds an up-to-date tax code, most lump sum withdrawals from a pension plan will be subject to income tax under the emergency rate basis. Triviality payments and winding up lump sums are taxed at basic rate.
The newsletter confirmed that providers must apply a temporary income tax code, called emergency rate, to any lump sum withdrawals from a pension plan unless:
This means that it is likely that the majority of initial withdrawals are likely to be subject to emergency rate tax. It’s worth noting that this is how PAYE operates and is not as a result of the pension freedoms.
Under the emergency tax code the amount being withdrawn is treated as if it will continue to be paid each month. Although in many cases it will actually be a one-off payment – known as the 'Month 1' basis.
The provider will therefore apply 1/12th of the personal allowance (£12,570 for 2021/22 to 2025/26) to the payment, and will assess the remaining payment against 1/12th of each of the income tax bands currently in force.
Emergency rate tax is calculated on the UK tax rate
Example: Fund value £50,000. £12,500 is taken as tax-free cash with the balance of £37,500 being taxed as follow:
|Annual Tax Band||Month 1||Tax rate||Tax due|
|Personal allowance||Up to £12,570||£1,047.50||0%||0|
|The remaining income (i.e. £37,500 - £1047.50 = £36,452.50) is then taxed at:|
|Basic rate band||£37,700||£3,141.67||20%||£628.33|
|Higher rate band||£37,700 -
|Additional rate||Over £150,000||£23,952.50||45%||£10,778.63|
|Total tax due||£15,150.29|
Since most people will not in fact receive this payment every month, in the majority of cases, this treatment will result in an overpayment of tax. The exception would be where the client receives income in excess of the additional rate tax threshold from another source(s). In this circumstance the personal allowance will not apply as the personal allowance is reduced by £1 for every £2 earned over £100,000.
Under PAYE where income tax has been overpaid it will normally be recovered through an adjustment to the tax code for future income payments.
In the case of a pension, HMRC will issue a revised tax code for the provider to apply to future payments.
However, where an individual is taking their pension fund as a lump sum, it is possible that they may not have any ongoing income against which the additional tax can be offset. In this case the individual has 2 options:
There are 3 forms available for reclaiming overpaid tax as the result of a lump sum pension payment.
Advisers can guide them towards the correct form by asking 3 basic questions:
You will note from this that individuals who intend to make further lump sum withdrawals and/or take income in the current tax year are expected to wait until HMRC issue the revised tax code. This is why there is no form which covers this situation.
You can find links to all HMRC Newsletters on our website.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.