Overtaxing of money drawn from pensions
One of the issues arising from the ‘pension freedoms’ is that people who take lump sums out of their pension funds have found themselves over- taxed on an ‘emergency’ basis. This can leave them with considerably less money than they expected while they seek to reclaim the overpaid tax from HMRC.
Outside of the 25% tax free cash sum which may be taken from a pension fund, free of income or capital gains tax, we pay tax at our marginal rate of income tax on all other money taken from the fund.
The problem arises where lump sums are taken, because HMRC has pension providers deduct tax as if you were going to take out this sum every month. So, if you draw £15,000 out, even if you are normally a basic rate taxpayer, HMRC assumes you will draw that sum out every month and taxes you at the higher rate.
Quarterly figures published by HMRC in their August Pension Schemes Newsletter revealed that more than 17,000 people had reclaimed some £46m in tax in the period April-June 2019. The total amount which taxpayers have had to claim back is now around £480m and is expected to pass the half a billion-pound mark.
The figures show the extent to which the HMRC rules are catching people out. It can come as a nasty shock to draw money out from a pension for a specific purpose only to find HMRC takes a large proportion in tax.
Reclaiming is not made easy; one of three different forms needs to be completed to claim the tax straight away, or people have to wait until the end of the tax year to claim back the excess tax via the self-assessment form.
Where large sums are involved, it can pay to seek advice before taking money out of a pension, both to avoid emergency tax but also in respect of the new death benefits that are available to pensions, which allow them to be passed on to beneficiaries tax free or at their marginal rate of tax, depending at what age the benefactor dies.
Don’t get penalised by pension rules
People taking a hybrid retirement - i.e. continuing to work part- time while also accessing a pension pot as needed - who are able and/or wanting to keep paying into a pension while they can, can find they are penalised by HMRC.
Since the introduction of ‘pension freedoms’ in April 2015, savers aged 55 or above have been able to draw money out of their pensions in tranches rather than turn the whole pension pot into an inaccessible annuity.
However, to prevent people from repeatedly taking money out of their pension, on which they have benefited from tax relief, and putting it back into their Pension again, thereby receiving the benefit of tax relief on the money twice, HMRC introduced a limit on the amount people could pay into a pension once they had started drawing taxable cash.
This limit, known as the Money Purchase Annual Allowance (MPAA), was originally set at £10,000 per year but has since been cut to £4,000 per year. This compares with the standard annual allowance which allows people to pay in up to £40,000.
In general, someone taking money out of a pension pot is affected by the MPAA if they draw money out beyond the 25% tax-free lump sum. With data showing that many more people are taking a hybrid retirement route, drawing income from their pension but continuing to work because it best suits their lifestyle or needs, it can make sense for them to continue paying into a pension and replenishing their pot. This rule therefore can penalise them for wanting to continue to save for their future retirement years.
Where people can get caught out is when they are part of their employer’s auto enrolment scheme, which adds employer contributions to their own and so can breach the £4,000 limit.
This scenario shows that planning how we best take money from our retirement savings is ever more important in the new pension environment, to ensure we do so as tax efficiently as possible and in our best interests.
Lowes Financial Management has been successfully managing people’s retirement planning for decades, helping to preserve family wealth for generations. We will analyse your pensions, savings and investments to provide a range of scenarios that allows you to make informed decisions based on a real understanding of your options.
To arrange a free initial consultation with a Lowes Consultant
Call: 0191 281 8811
Lowes Financial Management, Fernwood House, Clayton Road, Jesmond, NE2 1TL. Authorised and regulated by the Financial Conduct Authority.
The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.