The Pension Schemes Act 2015 introduced major changes to the way individual pension savers could access their defined contribution pensions.
The Act‘s contents are commonly referred to as Pension Freedom and Choice because it changed the requirement that a pension pot must generally be used to provide an income for the rest of your life and introduced more choice and flexibility.
Many pension savers welcomed these changes as the necessity to purchase a fixed annual pension income, known as a lifetime annuity, was seen as too rigid and the annuity rates at that time were regarded as not providing good value for money.
One of the choices introduced will allow you to have your entire ‘pot’ paid as cash in one lump sum. Whilst 25% of the pot is paid tax free the remainder is liable for income tax. One consequence of doing this is that many people are overpaying the amount of tax due on the sum paid to them by their pension provider.
Between January and March 2020 HMRC reported around 300,000 individuals took their entire pension pot as cash, but in doing so many of them may have been overtaxed.
HMRC rules stipulate that until your tax code is provided by HMRC to the pension scheme an emergency tax code must be applied to the payment. If the payment made is relatively small in pension terms, the application of an emergency tax code can result in tax being paid at 40% on part of the payment.
If this happens you can reclaim overpaid tax from HMRC by submitting a form before the end of the tax year. Alternatively, you can wait until the end of the tax year when HMRC should assess each individual for tax due on the amount received and automatically refund any excess tax paid.
HMRC say they will refund any overpaid tax within 30 days of receipt of a correctly completed form, however, the system used by HMRC penalises those who will not owe a significant amount of tax on the sum paid. Also, the people affected are likely to be those in most need of the money and least able to understand the steps they need to take to recover the overpayment immediately.
You can avoid this situation by choosing an alternative option provided under the pension freedoms for example you can take smaller amounts of money over a number of years (rather than a one off lump sum), but in many cases an alternative may not provide you with the ideal outcome in your particular circumstances.
Until HMRC has a change of heart and changes their rules you should be aware of the taxation consequence of having your entire pension pot paid as a single lump sum.
For more information about the Pension Freedoms and Choice for defined contribution pension schemes and taxation on pensions visit the Usdaw pension website at: http://www.usdaw.org.uk
For information about reclaiming overpaid tax on small pension lump sums visit HMRC here.
The content of this publication is intended solely for educational and general information purposes. It does not constitute any form of advice or recommendation by Usdaw and is not intended to be relied upon by users making (or refraining from making) any specific financial or other decisions. Usdaw has used its reasonable endeavours to ensure the information contained in this publication is accurate and error-free. However, Usdaw cannot warrant that the information does not contain inaccuracies or typographical errors.
Usdaw cannot provide members with individual tax or accounting advice. The content of this document should not be relied on for, tax, legal or accounting advice.