Savers accessing their pension funds through income-drawdown plans will continue to face excessive tax charges when first taking out their money because the government has refused to change the rules to remedy the problem.
The problem potentially affects millions of people accessing their savings as they move into retirement. Income-drawdown plans allow savers to withdraw as much of their money as they want, with many people taking a significant lump sum out of their pensions when they first begin spending their savings. But pension providers are required by HM Revenue & Customs (HMRC) to treat their first withdrawal as if the same sum will be drawn down in every month of the tax year. The tax deducted from such payments is therefore far more than is owed.
Tens of thousands of savers have already been caught out by this trap, with HMRC having made almost £300m refunds of overpayments since the pensions freedom reforms came into effect in April 2015. The tax service has previously said that it is processing more than 10,000 refund claims every three months.
While it is possible to make a claim for a refund as soon as the excess tax charge has been made, many savers don’t spot the problem straight away. As a result, they may remain out of pocket for some time, often until they file their annual tax return, when the anomaly will come to light.
A call for changes
Earlier this year the Office of Tax Simplification, the body that advises the Treasury on tax reform, said the government should review the way in which emergency tax codes are now routinely applied to savers using income-drawdown plans. However, while the plans have become the most popular way for savers to take pensions cash, HMRC said last week that a review of its processes had concluded that making changes would not be in the interests of most savers. Reform “would not significantly improve the tax position for the majority of recipients”, it argues.
That has disappointed pension advisers, who say the problem is relatively straightforward to fix. While pension providers currently have to apply a “month 1” tax code to income-drawdown withdrawals, which assumes the same sum will be withdrawn in each of the following 11 months, HMRC could switch to a “month 12” approach; any underpaid tax on subsequent withdrawals could then be recouped through savers’ tax returns. So far, however, HMRC has rejected calls for such an approach.
A way around the pitfall
One way around the emergency tax code issue is to make a very small first withdrawal when accessing your income-drawdown plan. There is nothing to stop you subsequently making a much larger withdrawal, but it is the first withdrawal made that sets the tone for the tax rate you should pay.
Assume that you choose to withdraw an amount as small as £1. Even with HMRC’s emergency tax calculations, this should not trigger a tax liability. However, it will prompt the authority to issue an up-to-date tax code that can be applied to subsequent withdrawals. Just keep in mind that you will need to put aside any money needed to pay any additional tax due at the end of the tax year.
Alternatively, if you do end up paying too much tax, ask for a refund straight away, using one of three HMRC forms to make your claim. If you’ve only withdrawn part of your pension savings, complete form P55 to get a refund of overpaid tax. If you took your whole pension pot as cash, you need form P50Z if you’ve stopped working or P53Z if you’re still receiving any other income.
All three forms can be completed online via your HMRC account, or you can file them by post. The tax authority is then meant to issue refunds within 30 days, although it’s worth being aware that it does not always meet this deadline.
Test case could boost women’s pensions
Three female members of the Lloyds Banking Group occupational pension scheme are taking its trustees to court over rules that mean their pensions increase in value more slowly than those of their male counterparts. The outcome could have significant implications for many pension schemes.
The issue dates from the way millions of people were encouraged to contract out of the state earnings-related pension scheme (Serps) during the 1980s and 1990s. Both employees and employers paid less national insurance, but the employer’s pension scheme had to pay at least a guaranteed minimum pension (GMP) broadly equivalent to what their staff would have got under Serps. The rules allowed the GMP for women to be paid at lower rates than men, on the grounds that women retired earlier. When changes in the law in 1990 forced pension schemes to equalise pension ages for men and women, the GMP issue wasn’t spotted and many women went on accumulating less valuable GMPs until 1997, when the system changed.
The potential cost to the Lloyds pension scheme of losing the case is thought to be as high as £500m, but the hearing is seen as a test of the law that will then apply to thousands of other schemes. Up to five million women are affected by the GMP issue and could be owed some £20bn, says the BTU trade union. That suggests average compensation of £4,000 for all those affected.
Tax tip of the week
Until recently, if you needed to report a capital-gains tax (CGT) liability, you had to complete a self-assessment tax return. Now you have a choice, says the Tax Tips & Advice newsletter. You can either file a return as normal, or you can use HMRC’s new CGT real-time service. The advantage to the new service is mainly speed, but it might also save you from having to complete a tax return at all if you’re not in self-assessment and don’t want to get sucked into the system. Just keep in mind that an accountant can’t use the service for you. Moreover, as you pay CGT at the time of reporting it, events later in the tax year might affect the amount of CGT payable. And if it turns out that you’ve paid too much, there is no clear procedure on how you get it refunded. “Overall, our view is that real-time CGT should be avoided until it improves,” says Tax Tips & Advice.