Bernadette Lewis: Emergency tax and pension lump sum withdrawals

In her latest technical article for Retirement Planner, Bernadette Lewis looks at the perils of pension lump sum withdrawals and emergency tax codes...

Pension freedoms allow clients to take large lump sums from their pension pots.

Income tax is calculated using pay as you earn (PAYE), but this doesn’t work well with large one-off payments. Clients often have too much tax deducted and have to reclaim their overpayment.

This can apply under both emergency tax rules and when the provider has the client’s PAYE tax code.

This makes it difficult for clients wanting to take set amounts from their pensions after tax, for example, to buy a car or repay debt. Care is needed to make sure they don’t take unnecessarily large amounts from pensions to cover tax that’s refunded later.

Advisers can help their clients consider alternative sources to make up cash differences while waiting for tax refunds.

It appears this problem will persist for some time yet. Disappointingly, the recent Autumn Budget was silent on any possible reforms tidying up anomalies such as these. A move to the treatment applying to pension ‘small pots’ – where the taxable amount is liable to basic rate income tax at 20% – would simplify matters greatly.

Our examples illustrate the principles but real-life tax calculations can give slightly different outcomes.

Emergency tax

The emergency tax basis treats lump sums as if the client receives the same payment every month for the whole tax year.

So a £10,000 lump sum is taxed as if the client is receiving £120,000 in a year, even if they’re taking their entire fund in one go.

The personal allowance and tax bands are divided by 12 and applied to the pension payment:





Tax codes

Providers may be able to use PAYE tax codes provided by HM Revenue & Customs (HMRC).

However, this can still result in excess tax being deducted initially. For 2017/2018, most people with one pension and no earnings will have a 1150L tax code.

This identifies that the provider should use a proportion of the £11,500 personal allowance and the tax bands based on the tax month of payment. Other tax codes can take account of someone getting their state pension or receiving other income.

It’s possible to have a negative tax code.

Reclaiming overpaid tax

Most clients don’t need to wait until the end of the tax year for HMRC to refund any overpaid tax. Depending on their situation, they can complete one of three HMRC tax reclaim forms:

  • P50Z: payment used up their pension pot and they have no other income in the tax year
  • P53Z: payment used up their pension pot and they have other taxable income
  • P55: payment didn’t use up their pension pot and they’re not taking regular payments.

If they take part of their pension pot and intend to take further sums from their pension in the same tax year, HMRC will confirm the tax code to the provider.

Bernadette Lewis is financial planning manager at Scottish Widows