Emergency tax code: People often have to hand over more than they owe on pension withdrawals, then claim it back
The ’emergency’ tax people are often forced to pay on pension withdrawals is tackled by This is Money columnist Steve Webb this week, after he received a question from a disabled reader on the topic.
Those taking out a lump sum are judged as if this is the start of a series of monthly withdrawals, and taxed accordingly. They then either have to reclaim the tax themselves or wait for HMRC to give it back.
Government gurus at the Office of Tax Simplification recently called for a review of emergency raids on pension cash, but HMRC has signalled it is not planning any change for now though it will continue to monitor the situation.
A reader asks: I am severely disabled and get Disability Living Allowance and Employment and Support Allowance. I recently needed to withdraw £11,000 from my pension pot.
My financial adviser told Old Mutual to sell £18,000 which they did. They have sent me a payslip with tax paid of £6,454.95 which correctly they deducted at source.
Now HMRC have sent me a tax coding change from 1185l to 584l and 600T.
The ESA, DLA and my pension withdrawal are my only income. Should I claim a tax refund or do I really lose my 1185l code and part of my pension that is all I have to raise my family on?
My financial adviser said that I should apply for a tax refund, but now HMRC have sent this, it seems I lost out on my own money by a bigger margin than when I was able to work!
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Steve Webb replies: You should definitely claim a tax refund as you have paid far too much tax on your pension withdrawal.
When you take a lump sum from a pension under the new ‘pension freedom’ arrangements, HMRC behave in what I believe is a totally unacceptable way.
They tax you using something called an ’emergency tax code’ and in most cases this results in you paying far too much tax.
Steve Webb: Find out how to ask the former Pensions Minister a question about your retirement savings in the box below
They are in effect assuming that you will make a whole series of withdrawals over the course of the rest of the year and that this would take you into a higher tax bracket.
They make this assumption even if you have no intention of doing so. You then have to fill in one of three forms to get the excess tax back.
Since the new system came in, tens of thousands of people have had to claim back hundreds of millions of pounds in overpaid tax.
Yet despite the government’s own ‘Office of Tax Simplification’ asking HMRC to have another look at it, HMRC have recently announced that they are quite happy with the way the system works! Read what the OTS and HMRC said about this below.
There are three forms which you can fill in to claim back overpaid tax, depending on your specific circumstances.
For someone such as yourself who has taken a partial withdrawal but left money in your pension pot, you need to complete form P55.
For someone who has emptied their pot and is no longer in work, the form is the P50Z.
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And for someone who has emptied their pot but is continuing in employment the form is the P53Z.
You can read more about claiming back overpaid tax on your pension here.
In terms of your overall situation, as you know, your Disability Living Allowance is not subject to income tax, but your Employment Support Allowance is taxable.
Until you took your pension withdrawal, you had a tax code of 1185L which is HMRC’s way of saying you are allowed tax free income of £11,850 each year.
As your ESA is well below this figure you would not have paid any tax. What they have done now is to split this tax free figure into two parts – £5,841 to set against your ESA and the balance – £6,009 – to set against your pension.
Now that you have withdrawn £18,000, part of this is covered by the unused part of your personal allowance and then the rest should be taxed at the standard 20 per cent rate.
But because of HMRC’s absurd ’emergency’ tax procedure you have ended up having more than a third of your pension taken in tax.
Fortunately you can now claim back the excess tax, and I’m told that once you submit the paperwork you should get the money reasonably quickly.
However, in my view it would be far better to deduct standard rate tax from all withdrawals and then make any adjustments through the end-year tax return process.
What did Government gurus say about emergency tax raids, and what is HMRC’s stance?
‘More could be done to help people understand the tax implications of withdrawals from pension funds and the actions they may need to take,’ said the Office of Tax Simplification in a recent report.
‘The OTS would like to explore this further with HMRC, in addition to working to identify options other than initial tax deduction using emergency tax codes on personal pension lump sums, which generally results in the deduction of too much tax when the payment is made.’
HMRC gave an update on its position in its Pension Schemes Newsletter for June, saying it had been reviewing the current process for flexible pension drawdown payments.
‘We’ve concluded that any changes at the current time would not significantly improve the tax position for the majority of recipients of a flexible drawdown payment when compared to the process currently in place,’ it said.
‘The existing PAYE treatment of flexible pension drawdowns remains the most effective method of deducting tax in these cases and it reduces the risk of underpayments of tax arising.
‘We will however continue to keep the current process under review and monitor drawdowns and related claims.’
ASK STEVE WEBB A PENSION QUESTION
Former Pensions Minister Steve Webb is This Is Money’s Agony Uncle.
He is ready to answer your questions, whether you are still saving, in the process of stopping work, or juggling your finances in retirement.
Since leaving the Department of Work and Pensions after the May 2015 election, Steve has joined pension firm Royal London as director of policy.
If you would like to ask Steve a question about pensions, please email him at firstname.lastname@example.org.
Steve will do his best to reply to your message in a forthcoming column, but he won’t be able to answer everyone or correspond privately with readers. Nothing in his replies constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.
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If Steve is unable to answer your question, you can also contact The Pensions Advisory Service, a Government-backed organisation which gives free help to the public. TPAS can be found here and its number is 0800 011 3797.
Steve receives many questions about state pension forecasts and COPE – the Contracted Out Pension Equivalent. If you are writing to Steve on this topic, he responds to a typical reader question here. It includes links to Steve’s several earlier columns about state pension forecasts and contracting out, which might be helpful.
If you have a question about state pension top-ups, Steve has written a guide which you can find here.