Emergency rate tax - case study

In our emergency tax and lump sum withdrawals article we had a basic example showing how the tax is calculated. To help you we’ve produced another example which will make it easier for you to explain the tax implications.

What is it called?

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.
  • Emergency rate tax is calculated in the same way in Scotland as in the rest of the UK.
  • The taxation bands for non-emergency rate tax are different in Scotland to the rest of the UK.

This tax has a number of different names:

• emergency rate tax
• a non-cumulative rate or
• month 1 basis

We’re going to stick with emergency rate tax through the rest of this case study.

When does it apply?

Providers must apply emergency rate tax to any lump sum withdrawals from a pension plan unless:

  • The member 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 the majority of initial withdrawals are likely to be subject to emergency rate tax. It’s worth noting this is how PAYE operates and is not as a result of the pension freedoms.

How does it work?

Under the emergency tax rate the amount being withdrawn is treated as if it will continue to be paid each month, although in many cases it will actually be a one-off payment.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 (£12,500 in 2019/20) 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 not on different rates that may apply in Scotland or Wales. Though the refund for overpaid tax will be based on the actual tax due, which will depend on where your client is resident.

Fund value £100,000 – £25,000 tax-free and £75,000 taxable:

 Annual Tax BandMonth 1Tax rateTax due
Personal allowance Up to £12,500 £1,041.67 0% £0.00
The remaining income (i.e. £75,000 - £1,041.67 = £73,958.33) is then taxed at:
Basic rate band £37,500 £3,125.00 20% £625.00
Higher rate band £37,500 - 
£150,000
£9,375.00 40% £3,750.00
Additional rate Over £150,000  £61,458.33 45% £27,656.25
  Total tax due £32,031.25
  Total taxable

£75,000.00

  Net amount £42,968.75
    Plus PCLS £25,000.00
    Net paid £67,968.75

There is a significant amount of tax being deducted from the income part of the payment, £32,031.25. 
The following shows the actual amount of tax due (excluding Scotland).

 Annual Tax BandTax rateTax due
Personal allowance Up to £12,500 0% £0.00
The remaining income (i.e. £75,000 - £12,500 = £62,500) is then taxed at:
Basic rate band £37,500 20% £7,500.00
Higher rate band £37,500 - 
£62,500
40% £10,000.00
  Total tax due £17,500.00
  Total taxable £75,000.00
  Net amount £57,500.00
    Plus PCLS £25,000.00
    Net paid £82,500.00

As expected the actual tax due is lower, with only £17,500.00 due compared with the £32,031.25 deducted under the emergency tax rate basis. A refund of £14,531.25 would be due. This would be done by completing an online form.

What can be done?

The only way to stop emergency rate tax being deducted is to trigger HMRC into issuing a tax code, this can be done by crystallising a small amount say £100. HMRC would then issue a tax code to the provider so the correct tax would be deducted from future payments. What is not clear is whether the new tax code would be issued quicker than the refund of overpaid tax.

Considerations

It makes sense to make it clear to clients emergency rate tax applies in this type of situation, just so there is no surprise.

Although more tax is deducted 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 (FAD) or an UFPLS has been taken the Money Purchase Annual Allowance applies. This is important if the client is still able to make contributions. Using FAD and only taking PCLS would avoid triggering the MPAA.

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:

  1. Has the individual encashed the full value of their pension fund or only some of it?
  2. Does the individual have other source of income during the tax year in question?
  3. Is the individual intending to make further withdrawals from the pension plan in question?

3 forms available

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.

The forms are accessible and should be completed online, there is no facility to print off and fill in a paper-based version.

Further information

You can find links to all HMRC Newsletters on our website.

Note

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.

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.