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Emergency tax and lump sum withdrawals
An explanation of when emergency rate tax applies and confirmation of the process for reclaiming overpaid tax following lump sum withdrawal from a pension plan.
Key facts
- Unless a pension provider holds an up-to-date tax code, lump sum withdrawals from a pension plan will be subject to income tax under the emergency rate basis
- This will result in an overpayment of tax for the majority individuals making their first withdrawal from their pension
- The overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose
- The taxation bands are different in Scotland to the rest of the UK.
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.
- This will result in an overpayment of tax for the majority of individuals making their first withdrawal from their pension
- The overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose.
When does emergency rate income tax apply?
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:
- The individual is able to provide a P45 from the current tax year following their withdrawal from employment and/or their current pension plan, or
- The pension provider already holds a P45 or up to date cumulative tax code received from HMRC as the result of previous withdrawals from that pension plan, and can apply it.
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.
How does the emergency tax code work?
Under the emergency tax code the amount being withdrawn is treated as if it will continue to be paid each month.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 - £125,140 | £7,286.67 | 40% | £2,914.67 |
| Additional rate | Over £125,140 | £26,024.16 | 45% | £11,710.87 |
| Total tax due | £15,253.87 | |||
| Total taxable | £37,500.00 | |||
| Net amount | £22,3246.13 | |||
| Plus TFC | £12,500.00 | |||
| Net paid | £34,746.13 | |||
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.
How can individual get their overpaid tax back?
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 two options:
- They can wait until the end of the tax year. A tax refund will be created as a result of the information submitted in their tax return OR
- They can reclaim the overpaid tax from HMRC during the tax year using the appropriate claim form. For an individual where the overpayment is substantial this is likely to be the preferred route.
What are the tax repayment forms called?
There are three 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 three basic questions:
- Has the individual encashed the full value of their pension fund or only some of it?
- Does the individual have other source of income during the tax year in question?
- Is the individual intending to make further withdrawals from the pension plan in question?
If the client intends to encash their full pension pot and they have no other source of income then form P50Z is required.
If the client intends to encash their full pension pot and they do have another source of income then form P53Z is required.
If the client only intends to encash only some of their pension pot and they don't intend to take any further payments or income from it just now then form P55 is required.
If the client only intends to encash only some of their pension pot and they do intent to take any further payments or income from it HMRC will confirm the tax code to be used.
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.
P50Z - Income Tax: claiming tax back when you have stopped working
P53Z - Income Tax: repayment claim when small pension taken as a lump sum
Further information
You can find links to all HMRC Newsletters on our website.
Disclaimer
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.