On The Money to the Masses Podcast, Damien Fahy explained how a pensioner paid an additional £5,000 in tax a year as a result of him taking his pension annually. Those approaching retirement need to be aware of this tax “quirk” as it can be a “nasty shock” when the money received isn’t what they planned for.
He said: “If you take a lump sum from a pension that is taxable then you effectively get put on a special tax code called month one tax code.
“It’s effectively an emergency rate tax, because you’ve got to think what happens with taxation is that if you have multiple pensions, you can have multiple tax codes for those pensions.
“What happens is HRMC doesn’t know how much tax you’re going to pay so when you end up drawing the money out of that pension pot, they think you’re going to be earning £25,000 a month for the next year so they apply taxation according to that assumption which is the emergency rate.”
This emergency tax code has caused thousands of people to be taxed at the higher rate of 40 percent because HMRC assumes the lump sum will be taken out monthly, resulting in more income for that person.
This is impacting 30-40 thousand people a year who are drawing lump sums from their pension but do not realise the effects of this.
Approximately, more than £700million has been overpaid in tax since 2015 when Pension Freedoms were introduced.
The Pension Freedoms legislation enabled consumers to flexibly access their defined contribution pension pots from the age of 55.
People can use the funds for a wider range of options including cash withdrawal, retirement income products, or a combination of the two.
“People nearing retirement that want to take money out of their pension in excess of their tax-free lump sum – they may look at the amount of money that’s to come out and they might know their tax position.
“They think if I take out £20,000 it’s taxable yes – they’ll work out their tax bill and what they think they might be left with, and they’ll have a nasty shock because they are left with much less,” he added.
When discussing the pensioner who overpaid £5,000, Mr Fehy added: “The guy received less money from his pension net, so he had to then withdraw money from another pension to try and make up the shortfall.”
Fortunately, this money can be retrieved using self-assessment tax forms which can be used to claim overpaid tax over an 18month period.
“P55 which is for people who have taken part of their pension and intend to take further payment.
“There’s a P53Z which is where people have taken all their pension, but they have other income.
“Those three forms allow you to reclaim the overpaid tax on the large pension withdrawal within the 30 days, you should just work out which one suits your circumstances.
“So speak to HMRC if you’re not sure.”
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