The 2015 Budget heralded the most radical changes to private pensions in a generation. But the tax treatment of lump-sum withdrawals means that many people are paying too much under bizarre pension tax rules. Steven Turnbull investigates.
This relatively new found freedom and choice in pensions means that you no longer have to purchase an annuity with your defined contribution pension and that there are other options available to you. The tax rules were changed to give people greater access to their pensions, drawdown of pension income is taxed at marginal income tax rates rather than the previous rate of 55% for full withdrawals. The tax-free lump sum continues to be available but there are six options available to you including:
1. Leaving the pension pot untouched
2. Purchasing an annuity
3. Getting an adjustable income (Flexi Access Drawdown)
4. Taking cash in chunks (Uncrystallised Funds Pension Lump Sum)
5. Cashing in the whole pot in one go
6. and mixing any of the options
As you can imagine, these new ppension freedoms have proved to be hugely popular. Whilst few people have blown their life savings on an expensive sports car or a round the world trip, many have enjoyed the ability to choose just how much of their pension they want to spend now, how much to use to reduce their debts or to go on investing with and how much to choose to turn into a regular income.
But there is one aspect of the new pensions regime that is proving to be much less popular, namely the tax treatment of lump-sum withdrawals. Income drawn from a defined contribution pension (in excess of a tax-free lump sum) is unsurprisingly added to taxable income for the year in question. Large lump-sum withdrawals can therefore result in individuals moving into a higher tax bracket and provide an incentive to spread withdrawals over multiple tax years. But even people who choose to make a relatively small withdrawal can find themselves with a surprisingly large tax bill which they have to then claim back in whole or in part from HMRC.
This is because of the rather bizarre way that HMRC has chosen to administer the taxation of these withdrawals. Normally, pay as you earn income tax works on a cumulative basis, meaning that people pay the right amount of tax each month and so that by the end of the year they have paid the correct amount. However, pension lump sums over £10,000 are taxed on a non-cumulative or ‘Month 1’ basis. What this means is that, if the pension provider has no tax code to use (which most will not have), then the individual is taxed as if they were going to make the same lump sum withdrawal every month. This means that one month’s worth of the annual tax-free allowance of £11,500 is quickly used up and far more tax is deducted than is necessary.
Research has found that whilst large numbers of people are making lump sum withdrawals from their pensions, relatively small numbers of people are going through the process of claiming back the overpaid tax. As a result, large numbers of people are almost certainly paying too much tax, a significant problem if they want to use the lump sum for a particular purpose and find out that the after-tax figure is much less than they expected to receive.
HMRC could stop using the ‘Month 1’ approach and instead simply deduct the basic rate tax at 20% from all taxable lump sum pension withdrawals. Most pensioners pay tax at the basic rate in retirement anyway, so deducting 20% should be the right answer for most modest withdrawals. These people would no longer be over taxed and then have to reclaim it from HMRC, simpler and easier for everyone concerned.
For those making larger withdrawals or those who would be higher rate taxpayers, additional tax will still be due. Higher rate taxpayers tend to complete an annual tax return and they could declare their pension withdrawal through that, allowing the extra tax due to be calculated and collected. For non-taxpayers, a 20% withdrawal would still represent too much overpaid tax but this would be much less than under the current rules and they could still be encouraged to claim back any excess in the usual way.
The current tax treatment of lump-sum withdrawals from pensions appears quite unfair, given its reliance on individuals to understand the subtleties of cumulative and non-cumulative taxation. It can then also be time consuming to then have to claim back overpaid tax.
Now that pension freedoms have been up and running for more than 2 years, it would be much better if people paid the right amount of tax from the start, along with a simple system to adjust the figure for those on the highest or lowest incomes.
If you need help and advice regarding your retirement and the new pension regime, please don’t hesitate to get in touch with one of the team here at JRW.