Pension withdrawals: an emergency best avoided

Many savers are paying too much tax on their pension withdrawals, says David Prosser.


HMRC's emergency tax code is a potential disaster you want to avoid
(Image credit: Copyright (c) 2015 Shutterstock. No use without permission.)

A flaw in the tax system means tens of thousands of people pay too much tax on pension withdrawals, forcing them to claim refunds from HM Revenue & Customs (HMRC). The problem, first identified when the pensions freedom reforms came into force in April 2015, has now reached epidemic proportions, with the industry calling on HMRC to change its procedures.

The issue affects savers who withdraw cash directly from their pension funds, rather than buying an annuity. When HMRC is notified of a withdrawal, its systems automatically assume that the sum taken out will then be withdrawn each month thereafter the tax due is worked out on this basis. In practice, however, many such withdrawals are one-offs, and savers' actual tax bills on these lump sums are often far lower.

How to avoid overpaying

In theory, for example, a saver withdrawing £10,000 from a pension fund should pay no tax (assuming they have no other income), because it would fall within their £11,850 annual personal allowance. But HMRC would typically demand £3,000 of the withdrawal, assuming that a series of withdrawals of the same amount will take place.

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Savers are entitled to claim back overpaid tax, but the process is complicated, with different forms to be completed depending on your circumstances. Those who don't claim a refund should get their money back once they have filed a self-assessment tax return. Some 10,000 savers filed claims for tax refunds during the first quarter of 2018 alone, says HMRC. Refunds for the quarter totalled £22m, taking the total value to £305m since pensions freedom reforms were introduced.

Savers are only protected from the emergency tax trap if their current tax code is up to date, typically because they've made a previous withdrawal from their savings in the same tax year; HMRC is then able to apply the right calculation. However, the system must be revamped, say campaigners, because the majority of savers are being caught out by the way in which the process works.

In the meantime, a saver's best hope of avoiding the problem is to start with a token withdrawal as little as £1, say. Even with HMRC's emergency tax calculations, this should not trigger a tax liability, but it will prompt the authority to issue an up-to-date tax code that can be applied to subsequent withdrawals.

Be on your guard against conmen

The pensions freedom reforms have triggered a spike in fraud, new research shows. Almost one in ten over-55s believe that they have been targeted by a con artist over the past three years, according to insurer Prudential. Of those surveyed, one in three said the risk of losing their savings to a fraudster had become a major concern.

The most common scams relating to pensions freedom have involved offers to unlock pension funds early; claims that a pension transfer would be a good idea; and the promotion of alternative investment schemes promising unrealistic returns from unconventional assets such as wine, cryptocurrencies or other unregulated assets.

The data also suggests that official data understates the scale of the problem; 82% of those targeted said that they had not officially reported the approach often because they did not know who to speak to.

Action Fraud, the UK's national fraud reporting centre, says it knows of fewer than 1,000 people who have actually lost money in a pensions fraud, with total losses of £22m from such scams since the pensions freedom reforms launched. However, you should always be on your guard, and remember the golden rule: if a scheme sounds too good to be true, it is.

Don't miss out on this tax break

Couples planning their financial future often make good use of opportunities such as joint tax allowances, but too few people are exploiting the opportunity that non-earners or low-earners have to invest in a pension and secure valuable tax relief.

Ordinarily, the rules on pensions allow UK-resident taxpayers under the age of 75 to contribute as much as they earn each year to their pension, up to a maximum of £40,000. But this annual allowance isn't available to those with no earnings, or those who earn so little that they pay no income tax; this includes many spouses who aren't in employment or work relatively few hours perhaps because they have caring responsibilities, for example.

However, a separate allowance of up to £3,600 is available to anyone in this position. Moreover, even non-taxpayers are still entitled to 20% tax relief on their contributions; this reduces the cost of a £3,600 contribution to just £2,880.

For higher earners in particular, whose ability to fund pension savings may be limited by the standard allowances, a spouse's pension can be a good way to make additional tax-efficient provision for retirement.

Even couples not coming up against pension contribution caps should consider the £3,600 allowance, which can be a useful way to establish an independent pot of pension savings. The same rules can also be used to make pension provision on behalf of children.

Tax tip of the week

HM Revenue & Customs (HMRC) has put plans to introduce a new digital reporting system for income tax on hold, says Lucy Warwick-Ching in the Financial Times. HMRC's "Making Tax Digital" plan had aimed to create a digital tax system for individual taxpayers and businesses, operating in "as close to real time" as possible. Since April 2017, all taxpayers have had access to their own digital tax account, and the tax authority had set a date of 2020 by which it "wanted to be interacting digitally with all taxpayers". But last week, HMRC wrote to tax professionals to say that it is delaying its plans, in order to focus on preparing for Brexit. The delay will not affect landlords, the self-employed and partnerships, who will still need to file records digitally, and update their accounting records with HMRC every three months.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.