The (sometimes surprising) taxation of pension income

taxation on pension income

The amount of Income Tax deducted from a single pension lump sum withdrawal or the first payment of regular monthly payments can often be quite a shock and therefore we thought this guide might provide an explanation.

Income payments from pensions are subject to income tax but not national insurance. They are taxed under the PAYE (Pay As You Earn) regime in the same way as employment income. This means that if in receipt of regular income the tax paid during the tax year should be correct.

HMRC issue a tax code that is used by the pension provider to calculate the amount of tax due from the individual’s income. If the wrong tax code is used you could end up paying too much, or too little, tax.

Starting taking income

Issues and questions generally arise when income is first taken or large lump sums are taken either under flexi-access drawdown (FAD) or Uncrystallised funds pension lump sum (UFPLS), basically drawing a combination of tax-free cash and taxable income in one single lump sum. This is due to the tax code the scheme administrator has to use and how it is applied. In all cases for new income from a provider then the tax code will be used on a month 1 basis (emergency tax code).

The month 1 basis means that the income or lump sum can only utilise 1/12th of the annual personal allowance and 1/12th of each tax band. Take for example someone with an emergency tax code (which actually gives a full personal allowance) and a taxable payment of £10,000 (Gross – Pre Tax).

It doesn’t matter what other income you have for this first payment or when in the year it is paid, the emergency tax code on a month 1 basis is the same.

Gross income payment – £10,000
Less 1/12 of full personal allowance – £1,042

Taxable income  – £8,958

20% on £3,125 (1/12 of basic rate band)  – £625
40% on £5,833 (remainder in higher rate band)  – £2,333
Total tax payable  – £2,958

Net income payment  – £7,042

If you were going to take £10,000 each month, had a full personal allowance and this all started in April then this tax would be correct. However, if you have no other income then this would be an overpayment of tax of £2,958 which would need to be claimed back.

If you provide a tax code via a P45 for the current tax year then the provider can use this, although it will still be applied on a month one basis initially. This will therefore generally not make a great deal of difference to the calculation expect for the amount of personal allowance used may differ from the full amount used under an emergency tax code.

Ongoing Income

If you take ongoing regular income, even though the initial payments may be incorrect, as with PAYE on salary it will sort itself out within the tax year and you shouldn’t have to reclaim any tax or make any extra payments.

Reclaiming tax paid

If you don’t take regular income then it may be worthwhile reclaiming the extra tax paid during the tax year, this is possible even if the funds within the scheme have not been exhausted.

To reclaim tax within the same tax year the following forms should be used.

  • P55 to reclaim an overpayment of tax when funds have been flexibly accessed but the fund has not be extinguished.
  • P53 to reclaim an overpayment of tax on a trivial commutation lump sum or small pension pot taken as a lump sum.
  • P50Z to reclaim an overpayment of tax when funds have been flexibly accessed and the fund extinguished and you have also ceased to work or claim benefits.
  • P53Z to reclaim an overpayment of tax when funds have been flexibly accessed and the fund extinguished.

Alternatively if none of the above are completed HMRC will reconcile the tax paid at the end of the year and will provide a refund or amended tax code in the following tax year. This is the least hassle but will mean a significant delay in the refund.

If you would like to discuss your pensions or investments, please get in touch.

Credit: Thank you to Techlink Professional for contribution to the content of this article.