Don’t forget income tax when drawing your pension

Many people have not understood the tax implications of drawing down their money, meaning that savers withdrawing pension cash are handing over millions of pounds in income tax.

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Drawing a pension while working could push up your taxes
(Image credit: Thomas M. Barwick INC)

One in four people don't know there is a levy on pension income.

Savers withdrawing pension cash in record numbers are handing over millions of pounds in income tax, official figures reveal. The trouble is, many people have not understood the tax implications of drawing down their money.

More than 250,000 people withdrew cash directly from their pension funds during the third quarter of the year, HM Revenue & Customs (HMRC) said last week. This means 1.3 million people have now made five million withdrawals in the three-and-a-half years since the pension freedom rules came into force. Ministers are banking on receiving £400m more than previously expected in tax receipts from such payments during the 2018-19 financial year, according to data published by the Treasury alongside last month's Budget.

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The increasingly high-profile row over the way in which HMRC charges emergency tax on the first withdrawal from pension funds is part of the issue. Many people are paying far too much tax because HMRC treats a large initial withdrawal as if the saver intends to take out the same amount in every other month of the tax year. This overpayment must then be reclaimed. However, the broader issue is that many savers simply do not realise pension withdrawals, other than the first 25% of their funds, are subject to income tax in the same way as salaries, interest and dividends from savings and investment, and most other types of income. In fact, one-in-four savers think all pension income is tax-free, according to a survey published by insurer L&G.

Timing is key

Often, savers pay more tax than expected because they are looking at their pension income in isolation, rather than treating it in the same way as they would other forms of income. For instance, it's common for people to take money out of their pensions while still earning an income from work, perhaps as they shift to part-time employment early in retirement. But the snag here is that these withdrawals may move them into higher tax bands requiring them to pay the 40% higher-rate tax on some or all of the income, for example, rather than the basic rate of 20%.

The result of this lack of awareness is that people often pay more tax on pensions income than necessary simply because of when they choose to access their funds. By waiting until they are no longer earning to make withdrawals, savers could end up paying income tax at a lower rate or enjoying zero-rate tax on more of their pension cash.

Are you getting the right GMP payout?

Up to a million pensioners could receive the wrong amount of pension money for years to come, warns consultancy Willis Towers Watson. The problem relates to a stand-off between HM Revenue & Customs (HMRC) and employers about the reconciliation of guaranteed minimum pension (GMP) benefits. The issue could affect anyone who was a member of an employer-run pension scheme between 1978 and 1997 that was contracted out of the state earnings-related pension scheme. Such members are entitled to GMP payments but in many cases, employers' records from this period do not match those of HMRC. As a result of this, some pensioners have been overpaid, while others have been underpaid.

HMRC issued guidance to pension schemes on how to resolve the problem and had given employers until 31 October to submit queries about the process. However, many schemes have missed this deadline or been unable to reconcile their records with those maintained by HMRC, so it is unclear whether pensioners are receiving the right payments or not. Such cases will now be dealt with one by one, with the backlog taking years to resolve. People who were overpaid may have to repay money (some schemes are waiving this) while those who were underpaid should eventually be compensated.

Barnardo's defeat bodes well for pensioners

A legal defeat for the children's charity Barnardo's will ensure thousands do not miss out on generous retirement benefit increases in years to come. The Supreme Court ruled last week that Barnardo's pension scheme trustees could not legally drop a promise to increase members' pensions in line with price inflation each year. The ruling is the final word on a four-year dispute that has been widely watched by other employers and defined benefit (DB) pension schemes.

Barnardo's had hoped to abandon its current policy of increasing pensions each year in line with the retail price index (RPI) in favour of rises linked to the consumer price index (CPI), on which inflation tends to be lower. The charity expected to reduce its pension liabilities by as much as £105m by switching. However, five Supreme Court judges unanimously agreed pensions law, combined with the detailed rules of the Barnardo's pension scheme, did not allow the charity to pick a replacement for RPI of its own choosing. Any new index would have to offer equivalent benefits, the judges said.

The ruling will make it significantly more difficult for other employers to try to reduce pension costs in this way, say pension lawyers. While every situation is potentially different, given variations in the way employers set up DB schemes, often many decades ago, the Barnardo's case sets a general precedent that other courts will follow.

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.