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Income tax considerations for pensions

Income paid from a UK pension fund will be paid under the Pay-As-You-Earn (PAYE) regime meaning this will be paid after tax has been deducted. This taxation can depend on when and how the withdrawal is being made.

This article discusses the application of income tax to pension income payments. Specifically, this will illustrate the potential taxation consequences on large taxable income payments in different circumstances.

There are many circumstances where a client determines they need a lump sum from their pension for a particular reason (holiday, mortgage etc). In these circumstances, they are more aware of the need for the cash rather than the associated income tax due. This tax can be illustrated by the use of HMRC’s tax calculator in many cases http://payecalculator.hmrc.gov.uk/PAYE0.aspx. The issue is not so much the fact that income tax will be taken but when it will be taken and the impact on the funds needed and when they are available.

Money paid from a UK pension fund in the form of income will be paid under the Pay-As-You-Earn (PAYE) regime meaning this will be paid after income tax has been deducted. The taxation of the pension fund can depend on when the withdrawal is being made, the size of the withdrawal and the tax code that the pension provider holds – or doesn’t have.

When the member first takes income from their pension, they will need a tax code to be provided by HMRC to the pension provider. This tax code will be applied to the income being taken from the scheme. If the client has a tax code provided before income has been taken this will be applied on a cumulative tax basis. In other words, if you are six months into the tax year your tax will be calculated by using proportionate allowances from the personal, basic and higher rate allowances, from the cumulative six month period (6/12ths of each allowance).. If, however, the provider has no tax code for the client at the point of taking benefits they will have an emergency tax code applied. Essentially this will only allow the client to have 1/12th of the personal and income tax allowances applied to the income payment. This process would also be repeated if the client can provide a current year’s P45 from their last employment (or from a transfer of a drawdown contract) and the emergency tax regime will be applied using the provided tax code rather than the full personal allowance. It is possible for the client to apply to HMRC to get a tax coding that can be used on a cumulative basis before taking pension benefits. If however, this is in relation to regular income payments this will not generally cause much of an issue and HMRC will quickly adjust and provide tax codes to ensure the provider removes the correct amount of tax for the client. Old Mutual Wealth has produced a guide that gives detail of this taxation process here.

The consequences of the different taxation methods and timings can be clearly illustrated by applying all these mentioned tax scenarios to the same example.

Scenario background

Stephen is looking to pay for his daughter’s wedding and honeymoon (possibly Cyprus) at an overall estimated cost of £25,000 and chooses to use his pension to fund this by flexibly accessing his benefits. Stephen has already taken tax-free cash a number of years ago to repay his mortgage but has never taken income. Stephen lives off investment capital and so considers himself a nil rate taxpayer with a full personal allowance available. As a nil rate taxpayer Stephen roughly calculates that he would need to withdraw £28,500 to cover the sum he needs, basing this on £11,000 personal allowance and the rest being taxed at basic rate tax of 20%, costing him £3,500 and leaving a fund of £25,000. However, this may not be the case.

The reason for this is not to do with the amount of tax but rather is based on the way the fund would be taxed, personal allowances and the timing of the tax.

Tax scenario 1 – tax code issued

Stephen has been issued a tax code of 1100L (full personal allowance) on a P45 based on leaving employment at the beginning of the tax year. Based on this the client goes to HMRC and requests a tax code to be issued to the pension provider. HMRC agree and presents this to the pension provider before taking benefits. The provider is looking to make this one off payment in the sixth accounting month of the tax year. On this basis the tax taken by the pension provider for £25,000 will be:

Tax band/allowance   1/12 value   Net income
0% £11,000   £5,500   £5,500
20% £32,000   £16,000   £12,8002
40% £118,000   £3,500 (residual income)   £2,100
Total net income Gross £25,000 Net £20,400

Total tax due and taken on pension income payment = £4,600 leaving funds of £20,400 immediately available.

Shortfall of £4,600 for needs, so:

£4,600/60 (after higher rate tax this represents 60% of the sum) x 100 = £7,666.66

So total fund needed to get an immediate net sum of £25,000 = £32,666.66

Tax scenario 2 – no tax code

The client has no tax code. Remember, an emergency tax code means the payment will be calculated as though the client has 1/12 of each of the personal allowance and tax bands, so:

Tax band/allowance   1/12 value   Net income
0% £11,000   £916.66   £916.66
20% £32,000   £2,666.66   £2,133.33
40% £118,000   £9,833.33   £5,900
45% over £150,000   £11,583.35   £6,370.84
Total net income Gross £25,000 Net £15,320.83

Total tax due and taken on pension income payment = £9,679.17 leaving funds of £15,320.83 immediately available.

Shortfall of £9.679.17 needed, so:

£9,679.17/55 (after additional rate tax this represents 55% of the sum) x 100 = £17,598.49

So total fund needed to get an immediate net sum of £25,000 = £42,598.49

Tax scenario 3 – pre-plan to get tax code

Stephen pre-plans the need for the lump sum payment from his pension and decides to take this right at the end of the tax year so that he can benefit from all 12 accounting months of the tax code for the year. Stephen, as in scenario 2, does not have a tax code. To create this code Stephen initially makes a small income withdrawal from the Collective Retirement Account in January or February of £100. By doing this Old Mutual Wealth, as the pension provider, will inform HMRC that Stephen has started taking an income and HMRC will send us a tax code to apply for him. In this scenario we will assume the tax code given is 1100L. This now means that any other income that Stephen takes will be subject to the cumulative tax basis.

In March, the last accounting month in a tax year, Stephen requests and takes the £25,000 taxable lump sum. As Stephen has received a tax code he can calculate the income tax on a cumulative basis:

Tax band/allowance   12/12 value   Net income
0% £11,000   £11,000   £11,000
20% £32,000   £14,000 (residual income)   £11,200
Total net income Gross £25,000 Net £22,200

Total tax due and taken on pension income payment = £2,800 leaving funds of £22,200 immediately available.

Shortfall of £2,800 needed at basic rate tax, so

£2,800/80 (after basic rate tax this represents 80% of the sum) x 100 = £3,500

So total fund needed to get an immediate net sum of £25,000 = £28,500

Assuming the wedding costs approximately £20,000, leaving an assumed £5,000 for the honeymoon, Stephen’s daughter may not be having the honeymoon they had planned unless more of the pension fund is encashed, with scenario 2 being closer to Skegness and scenario 3 closer to the desired destination of Cyprus.

Reclaiming the tax

In all circumstances mentioned in the above scenarios the client will have likely paid the incorrect amount of tax. To be able to reclaim this tax the client can wait and apply for reclaims and adjustments through their self-assessment tax returns. Alternatively there are a number of forms that HMRC provides that can be used for immediate tax reclaims. These forms cater for different tax scenarios, (i.e. only income, income from other sources in addition to the pension etc) and can be found here.

Alternatives

As stated, Stephen has been living off investment assets and so these may provide other potential alternative options to fund his daughter’s wedding, including;

ISA

If Stephen has ISAs these could be used to provide the immediate income needed for his daughter’s wedding. In this way there is no income tax liability that needs to be considered. This could also be seen as a short term solution while waiting for the income tax excesses to be refunded under the above mentioned pension withdrawals. With the new ISA rules you are able to withdraw and then replace money within the same ISA without affecting your ISA allowances where the provider allows this (currently not available through Old Mutual Wealth).

Investment bonds

Bonds can deliver up to a 5% tax deferred capital withdrawal each year until the initial investment amount has been claimed. If Stephen has bonds and has not been utilising his 5% withdrawal limits he may consider this route as an option to fund his daughter’s wedding. This does not avoid paying tax but could defer any tax bill until a later time. As Stephen is a nil rate taxpayer with no earned income he may also consider any offshore bonds that he has in his investment portfolio. Any chargeable gains triggered on an offshore bond are treated as savings income. This could mean that Stephen could offset any taxable gains that occur against a combination of his personal allowance, the £5,000 starting rate savings limit (available for those with earned income below £16,000), and also the £1,000 personal savings allowance.

Unit trusts

Any unit trusts and OEICs that Stephen holds could be used to provide a combination of income (again, treated as savings income), dividends to use the £5,000 dividend allowance and the £11,100 capital gains tax exemption.

Combination of methods

As briefly described above, there are many options and potentially tax efficient ways to take income and capital from investments and by using these allowances it would be possible for Stephen to take up to £33,100 without being liable for any tax, depending on his investments. In addition to this there are also tax deferral options (bonds) which may be convenient to use. All of these actions can be used to either try to fully cover, or at least partially cover, the costs relating to Stephen’s daughter’s wedding. These potential combinations are illustrated in our Knowledge Direct article ‘Savings and dividend taxation bands and allowances’.

 

Created July 2016 

For financial advisers only. Not to be relied on by consumers.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth or Old Mutual International's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. We cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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