I am aged 64, working full time, and due to get my company pension later this year. I have also got a SIPP which I have built up from my own pension savings. I would like to take some of that money out soon. Probably as a sizeable lump sum to partly spend, or maybe gift to my son.

From reading some articles I am worried I may have to pay a higher rate of tax on this lump sum. If so, can I avoid that? Or has that problem now been solved? I read something about that in the papers but am struggling to fully understand the situation.

Kev 

Rachel Vahey, AJ Bell Head of Public Policy, says:

Pension savers have a great deal of flexibility to decide how to take money out of their pension plans. As well as being able to take 25% of it as a tax-free lump sum (usually up to a total of £268,275 across all their pension plans), people can take the remainder out as a regular taxed income stream, which can be turned on or off, or increased or reduced whenever they want. It doesn’t have to be an income stream though; they also have the freedom to take ad-hoc taxed withdrawals, as and when it suits them.

If making an ad-hoc withdrawal, pension savers need to watch out for a pitfall which could see them hit with an unexpected tax bill possibly running into thousands of pounds. If they do nothing, then they will have to wait until the start of the next tax year to get their money back. And even then, they’re relying on the efficiency of HMRC in sorting out their tax position.

The problem can affect anyone who takes a taxable pension freedoms payment from age 55 either through drawdown or via an ‘Uncrystallised Funds Pension Lump Sum’ (or UFPLS for short). Note, that access age of 55 is rising to 57 from April 2027.

NO TAX CODE IS A PROBLEM

Where the pension saver cannot provide a current year tax code, HMRC requires their pension provider to use either an emergency tax code on a ‘Month 1’ basis, or if they have a current year P45 this is applied on the same basis. This means HMRC only gives them a 12th of the usual tax allowances available on the withdrawal. This results in many savers being severely overtaxed. A current year tax code is usually only supplied by HMRC after the first payment is made. 

For example, a pension saver with no current year P45 who has no other income and takes £50,000 from their pension pot – £12,500 as a tax-free lump sum and £37,500 as taxed income – would have to pay around £15,300 under the emergency tax code. Whereas the actual tax due is only around £5,000.

Pension savers can, however, take action to get their money back quickly, hopefully within 30 days.

They do this by filling out one of three reclaim forms. Which one depends on whether they are using up the pension pot entirely, and whether they have other taxable income.

HMRC recently announced a small change would be made to how the tax is worked out on taxable income from pensions. It said that from next April it would automatically update the pension saver’s tax code after the first  payment has been made, without the need for the pension scheme to separately notify them.

This means for those who are taking regular payments their tax situation will be sorted out much more quickly. But it doesn’t solve the problem for those who only take one payment in the tax year.

ONE POSSIBLE SOLUTION

So, a solution is maybe to take a small taxable withdrawal from the pension before taking the larger one. This will ‘set’ the right tax code for the later payment. Although people may not want this extra administration.

All of this adds up to extra hassle for a pension saver wanting to take their first ad-hoc taxed withdrawal from their pension. And although HMRC are reasonably prompt in repaying overpaid tax, this time lag should be built into plans.

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