How do you avoid a 40% tax hit when taking a large amount of money from your pension pot? Steve Webb replies
My friend who is 63 recently cashed in his pension under the new rules announced last year.
He had £38,000 in his fund - he got 25 per cent tax free, but they taxed him on the remainder at 40 per cent even though he hasn't worked throughout the tax year and not claimed any benefits.
He should have been taxed at 20 per cent. He was told he had to get the refund from the tax office which in my opinion could be time consuming. My question is under similar circumstances how can this be avoided?
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Pension withdrawals: Some people are overtaxed and have to make a claim or wait to get their money back
Steve Webb replies: I’m grateful to you for raising this issue, as many thousands of people have almost certainly been over-taxed on the withdrawals they have made under the ‘pension freedoms’ since April 2015.
It is important that they are aware that they can indeed claim this tax back.
By way of background, when someone takes their money out of a pension beyond the age of 55, they can usually take one quarter tax free. If they take the rest as a lump sum then this counts as taxable income for the year in which they make the withdrawal.
You might suppose that HM Revenue and Customs would wait to the end of the tax year, look at how much total taxable income you have, and then send you a tax bill. But there are two reasons why this is not how it works.
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The first is that HMRC simply doesn't want to have to wait to get the tax. The second is that most people don’t fill in annual tax returns, so there isn’t any automatic way of making sure that the tax would get collected.
Instead, in most cases HMRC asks your pension provider to deduct tax before they pay out the balance of your pension fund.
Unfortunately, HMRC does this in a particularly strange way which means that most people end up paying too much tax and then have to claim a refund.
For small withdrawals of taxable income, those under £10,000, HMRC simply deducts tax at the basic rate of 20 per cent. This is probably a reasonable thing to do, though if your total income for the year turns out to be under the tax threshold (£11,500 in 2017/18) then you should claim back any tax.
But for larger withdrawals HMRC taxes you as if you were going to make a withdrawal like this every month.
Not surprisingly, if you made 12 withdrawals over the course of a year, each of more than £10,000, you would be well into paying tax at the higher (40 per cent) rate. This is why your friend ended up paying (roughly) 40 per cent in tax.
As you rightly say, this tax can be claimed back, and there is more information about how to do this here.
If you don't make a claim in the current tax year, HMRC should automatically calculate and refund you any overpaid tax in the following year.
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Waiting for HMRC to do this can save you the hassle of filling in forms - and maybe the expense of getting a tax accountant if your finances are complicated enough for you to need help with this task - but quite understandably you will want your money back as soon as possible if you have overpaid a large sum.
In my view it is absurd to overtax most people and leave them to claim a refund or wait a long time to get their money back. A much fairer system would simply be to deduct basic rate tax on all withdrawals.
For higher earners (who generally do fill in a tax return) any extra tax due could be collected at the end of the year. But for most people this would mean that roughly the right amount of tax was deducted from the start, which has to be a better system.
Until the rules change, there is not much that you can do about this. If the pension provider had a tax code for you then it could deduct the correct amount of tax first time round, but if you want the money quickly there might not be time to sort this out.
I have heard recently of one firm which encourages people to take just one pound of taxable income which triggers the process of getting a tax code sorted out.
Once this has been done, you can take the rest of your lump sum and the correct amount of tax is then deducted. You may want to discuss this with your pension provider, but it is pretty silly that people have to do this sort of thing to avoid being over-taxed.
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