Plenty of people have warned of the income tax implications of next month’s pension freedoms. As I wrote last year (How to spend it), someone drawing down £200,000 from a personal pension should expect to pay a minimum of almost £50,000 in income tax. That is even if they have no other taxable income. The Daily Telegraph has summarised this in a neat little table illustrating a number of different scenarios combining non pension income and the sum drawn down from your pension. The associated article can be read here.
The tax itself will be deducted at source by the pensions company and remitted to the Treasury.
What is less widely noted though is that, in the absence of a clear indication of what your tax code actually is, pension companies will apply an emergency tax code. This could easily be as high as 45%. Worse still, it will ignore any entitlement you will most likely have to take 25% of the pot tax free.
The situation arises because HM Revenue & Customs treats any money drawn as the first of a series of monthly payments. This is similar to what currently happens when pensioners draw down a regular monthly sum from their pension to live on. It is less helpful for pension freedom withdrawals, which are likely to be one-offs and involve far larger sums.
The good news is that the money isn’t lost for all time. However, the process of reclaiming it is complicated and easily misunderstood. If you have no other income apart from your State pension, you must complete a P50 form and return it to HMRC. It will then take up to six weeks to receive your refund. If you do have other sources of income you must complete a P53 form.
Alternatively you can wait until the end of the tax year at which point the overpayment should be corrected automatically. The downside of being patient is that HMRC will be sitting on many thousands of pounds of your cash. To put this in monetary terms, if you take my example of a pensioner with no other income withdrawing £200,000, the overpayment could be anything up to £40,000. The true income tax liability is an already chunky £49,000. However, applying an “emergency” 45% rate and ignoring any 25% tax free cash entitlement, could easily see £90,000 of your £200,000 being remitted to HMRC.
Take care out there