Emergency tax on pensions
When initiating the first pension withdrawal, it is common practice for the provider to apply an emergency tax code. This may result in either an overpayment or underpayment of tax by the individual. Pension providers are typically required to adopt this approach for initial withdrawals.
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, with the provider using an emergency tax code.
- This will result in an overpayment of tax for the majority individuals making their first withdrawal from their pension. But in some cases, it may mean that an individual underpays tax.
- The overpaid tax may be reclaimed during the tax year using one of the HMRC forms specifically designed for this purpose.
- Emergency rate tax is calculated in the same way in Scotland as in the rest of the UK.
- The tax bands for non-emergency rate tax are different in Scotland to the rest of the UK.
What are other names for emergency tax?
What are other names for emergency tax?
This tax is also known as:
- A non-cumulative rate.
- Month 1 basis.
We’re going to stick with emergency tax rate through the rest of this case study.
When does emergency tax rate apply?
When does emergency tax rate apply?
Providers must apply an emergency tax code to any lump sum withdrawals from a pension plan unless:
- The individual can provide a P45 from the current tax year following their withdrawal from employment and/or their current pension plan.
- 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 most initial withdrawals are likely to be subject to emergency tax rate.
How is the emergency tax rate calculated?
How is the emergency rate tax calculated?
Under the emergency tax rate, the amount being withdrawn is treated as if it will continue to be paid each month, although in many cases it will actually be a one-off payment.
The provider will therefore apply 1/12th of the personal allowance (£12,570 for 2021/22 to 2027/28 tax years) to the payment, and will assess the remaining payment against 1/12th of each of the income tax bands currently in force.
Emergency tax rate is calculated on the UK tax rate; not on different rates that may apply in Scotland or Wales. Though and refund for overpaid tax is based on the actual tax due, which will depend on where the individual is resident.
Examples of emergency rate tax calculations
Example 1 – individual has no other income and takes a £100,000 UFPLS payment.
Fund value £100,000 – £25,000 tax-free and £75,000 taxable:
| Annual Tax Band | Month 1 | Tax rate | Tax due | |
|---|---|---|---|---|
| Personal allowance | Up to £12,570 | £1,047.50 | 0% | £0.00 |
| The remaining income (£75,000 - £1,047.50 = £73,952.50) is then taxed at: | ||||
| Basic rate band | £37,700 | £3,141.67 | 20% | £628.33 |
| Higher rate band | £125,140 - £37,700 | £7,286.67 | 40% | £2,914.67 |
| Additional rate | Over £125,140 | £63,524.16 | 45% | £28,585.87 |
| Total tax due | £32,128.87 | |||
| Total taxable | £75,000.00 | |||
| Net amount | £42,871.13 | |||
| Plus tax-free cash | £25,000.00 | |||
| Net paid | £67,871.13 | |||
There is a significant amount of tax being deducted from the income part of the payment, £32,128.87.
The following shows the actual amount of tax due and assumes no other income (excluding Scotland).
| Annual Tax Band | Tax rate | Tax due | |
|---|---|---|---|
| Personal allowance | Up to £12,570 | 0% | £0.00 |
| The remaining income (£75,000 - £12,570 = £62,430) is then taxed at: | |||
| Basic rate band | £37,700 | 20% | £7,540.00 |
| Higher rate band | £62,430 - £37,700 = £24,730 | 40% | £9,892.00 |
| Total tax due | £17,432.00 | ||
| Total taxable | £75,000.00 | ||
| Net amount | £57,568.00 | ||
| Plus tax-free cash | £25,000.00 | ||
| Net paid | £82,568.00 | ||
As expected, the actual tax due is lower, with only £17,432.00 due compared with the £32,128.87 deducted under the emergency tax rate basis. A refund of £14,696.87 would be due. This would be done by completing an online form.
Example 2 – Individual has other income of £100,000
Applying emergency rate tax to a payment can, in certain cases, lead to an individual owing additional tax to HMRC.
The emergency rate tax calculation is the same as show in example 1.
The following shows the actual amount of tax due, assuming they have other income of £100,000 (excluding Scotland).
| Annual Tax Band | Tax rate | Tax due | |
| Personal allowance | Up to £12,570 | 0% | £0.00 |
| The remaining income (£100,000 - £12,570 = £87,430) is then taxed at: | |||
| Basic rate band | £37,700 | 20% | £7,540.00 |
| Higher rate band | £87,430 - £37,700 = £49,730 | 40% | £19,892.00 |
| Total tax due | £27,432.00 | ||
Amount of tax due on income of £175,000 (£100,000 income and £75,000 taxable element of the UFPLS payment).
| Annual Tax Band | Tax rate | Tax due | |
| Personal allowance | There is no personal allowance due to the level of income | £0.00 | |
| Basic rate band | £37,700 | 20% | £7,540.00 |
| Higher rate band | £125,140 - £37,700 = £87,770 | 40% | £34,976.00 |
| Additional rate band | £175,000 - £125,140 = £47,860 | 45% | £22,437.00 |
| Total tax due | £64,953.00 | ||
The tax due on the £75,000 taxable element of the UFPLS payment is £37,251 (£64,953 – £27,432). However, as the amount already paid through emergency tax rate is £32,128.87, this means there is an additional amount of £5,392.13 due to HMRC (£37,521 – £32,128.87).
Is it possible to avoid emergency tax on a pension lump sum or on drawdown?
Is it possible to avoid emergency tax on a pension lump sum or on drawdown?
Ideally an individual can stop the emergency tax code being applied by giving a relevant P45 to the provider. This needs to have been issued in the same tax year the individual wants to take money from their plan and it needs to be given to the provider before the first payment is taken. The provider will then apply the coding notice as stated on the P45 (on a month 1 basis) and deduct the correct amount of tax.
What needs to be considered in relation to emergency tax?
What needs to be considered in relation to emergency tax?
It makes sense to make it clear to individuals that an emergency tax rate applies in this type of situation, just so there is no surprise.
When a payment results in an overpayment of tax, HMRC are reasonably prompt when paying refunds, so you should balance whether taking a small payment and waiting for the tax code would be the best way to proceed.
Another important consideration is once income has been taken from a flexi-access drawdown plan or an uncrystallised funds pension lump sum, the money purchase annual allowance applies.
This is important if the individual is still able to make contributions. Using flexi-access drawdown and only taking tax-free cash will avoid triggering the money purchase annual allowance.
What forms are used to reclaim overpaid tax from HMRC?
What forms are used to reclaim overpaid tax from HMRC?
There are three forms available for reclaiming overpaid tax as the result of a lump sum pension payment.
Advisers can guide the individual 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?
Is the individual planning on taking all their pension savings from the plan?
Yes, they are taking the whole fund. Does the individual have another source of income in this tax year? If no, use form P50Z. If yes, use form P53Z.
No, the individual is only taking part of the fund. Does the individual plan on taking more money from the plan this tax year? If no, use form P55. If yes, HMRC will confirm the tax code.
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.
How can under paid tax be paid to HMRC?
How can under paid tax be paid to HMRC?
The individual can contact HMRC directly, or it can be added to their self-assessment tax return. It is also possible that HMRC will pick up on the shortfall when they carry out the individual’s end of year tax reconciliation. This may result in a coding notice adjustment.
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.