Emergency tax and lump sum withdrawals

An explanation of when it applies and how to get it back by Fiona Tait, Royal London

The timely newsletter 68 was published by HMRC at the beginning of April, nearly a whole week ahead of the implementation of some of the changes it covers.

One of the details not previously available was confirmation of the process for reclaiming overpaid tax following lump sum withdrawal from a pension plan.

Summary

Unless a pension provider holds an up-to-date tax code, lump sum withdrawals from a pension plan will be subject to income tax under the emergency rate basis.

  • This will result in an overpayment of tax for the majority individuals making their first withdrawal from their pension.
  • The overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose.

Emergency rate income tax

When will it apply?

The newsletter confirms that providers must apply a temporary income tax code, called emergency rate, to any lump sum withdrawals from a pension plan unless:

  • The member is able to provide a P45 from the current tax year following their withdrawal from employment and/or their current pension plan, or
  • The pension provider already holds a P45 or up to date cumulative tax code received from HMRC as the result of previous withdrawals from that pension plan, and can apply it.

This means that it is likely that the majority of initial withdrawals are likely to be subject to emergency rate tax.1

How will it work?

In conceptual terms, under the emergency tax code the amount being withdrawn is treated as if it will continue to be paid each month. Although in many cases it will actually be a one-off payment – known as the "Month 1" basis.

The provider will therefore apply 1/12th of the personal allowance (£10,600 in 2015/6) to the payment, and will assess the remaining payment against 1/12th of each of the income tax bands currently in force.

Example: Fund value £50,000 – £12,500 tax-free and £37,500 taxable:

 

Annual Tax Band

Month 1

Tax rate

Tax due

Personal allowance

Up to £10,600

£883.33

0%

0

Basic Rate

£10,600.01 -  £31,785

£2,648.75

20%

£529.75

Higher Rate

£31,785.01 -  £150,000

£9,851.25

40%

£3,940.50

Additional Rate

Over £150,000

£24,116.67

45%

£10,852.50

 

Total tax due

£15,322.75

 

Total taxable

£37,500.00

 

Net amount

£22,177.25

   

Plus PCLS

£12,500.00

   

Net paid

£34,677.25

Since most people will not in fact receive this payment every month in the majority of cases this treatment will result in an overpayment of tax.2

Getting the tax back

Under PAYE where income tax has been overpaid it will normally be recovered through an adjustment to the tax code for future income payments.

In the case of a pension, HMRC will issue a revised tax code for the provider to apply to future payments.

However, where a client is taking their pension fund as a lump sum, it is possible that they may not have any ongoing income against which the additional tax can be offset. In this case the client has 2 options:

  1. They can wait until the end of the tax year. A tax refund will be created as a result of the information submitted in the client’s tax return.
  2. The client can reclaim the overpaid tax from HMRC during the tax year using the appropriate claim form. For clients where the overpayment is substantial this is likely to be the preferred route.

Tax repayment forms

Newsletter 68 confirms that there will 3 new forms available for reclaiming overpaid tax as the result of a lump sum pension payment.

Advisers can guide their clients towards the correct form by asking 3 basic questions:

  1. Has the client encashed the full value of their pension fund or only some of it?
  2. Does the client have other source of income during the tax year in question?
  3. Is the client intending to make further withdrawals from the pension plan in question?

You will note from this that clients who intend to make further lump sum withdrawals and/or take income in the current tax year are expected to wait until HMRC issue the revised tax code. This is why there is no form which covers this situation.3

The forms are accessible and should be completed online, there is no facility to print off and fill in a paper-based version.

Further information

You can find copies of all HMRC Newsletters on their website.

Notes

1 Note this is a function of PAYE and not a result of the new pension freedoms.

2 The exception would be where the client receives income in excess of the additional rate tax threshold from another source(s). In this circumstance the full personal allowance would already have been used up and the client would be due to repay the 1/12th which was applied to the pension payment.

3 There have been suggestions that clients should make lump sum withdrawals in 2 stages. The first payment would trigger the new tax code and the second payment would therefore be taxed correctly. It is unclear however if this would result in a quicker adjustment than simply reclaiming the overpaid amount.


More articles