Techzone

Overview

When pension funds are crystallised, up to 25% of the crystallised amount can normally be taken tax free. Any payments from the balance are taxed as ‘non-savings’ income under the PAYE (Pay As You Earn) rules.

In practice, however, when a regular income starts to be paid (via lifetime annuity, scheme pension or income drawdown) or when ad-hoc payments are taken (via income drawdown or UFPLS), the amount of tax deducted will often be incorrect because the provider normally has to apply a temporary tax rate, referred to as ‘emergency tax’.

This applies not only to payments to the original member, but also to any taxable death benefits paid to beneficiaries, including taxable payments under beneficiary's drawdown.

The emergency tax code will not be applied to payments made under triviality, small pots rules or winding up lump sums, as these are normally taxed at the basic rate.

Emergency tax code – month 1 basis (M1)

In the majority of cases, schemes paying out a single or ad-hoc withdrawal, or making the first payment of a regular pension, will use an emergency tax code on a month 1 (M1) basis.

This doesn't take into account any previous payments made in the current tax year. Income tax is calculated using 1/12^th of the standard personal allowance and 1/12^th of the basic rate and higher rate tax bands. Anything above that is subject to additional rate tax.

For many, this will result in an overpayment of tax. However, for some - for example, additional rate taxpayers - it could result in an underpayment.  

The emergency tax code for the 2024/25 tax year is 1257L. This will give a tax-free amount of £1,047.50 (£12,570/12) and the rest of the payment will be taxable.

On the setting up of the annuity, or making the first regular drawdown income payment, providers will inform HMRC, who in turn will issue a tax coding to the pension provider.

Meeting a short term need

Some clients will wish to access their pension to meet a short term need. Where this could involve income taxed on the emergency basis, understanding emergency tax is key to deciding how much needs to be drawn to meet their needs.

Those with uncrystallised funds and access to income drawdown may be able to meet their needs purely by taking tax free cash.  

Where it’s necessary to take drawdown income that’s taxable using the emergency code, there’s a choice to be made - whether they withdraw:

• an amount which, after deduction of emergency tax, gives a net payment that immediately matches the cash need 
   
  or

• a lower amount, which will match the cash need once any overpaid tax has been reclaimed

This example demonstrates how PAYE will operate on withdrawals of taxable income.

In reality, many individuals will be taking their income as a combination of tax free cash and taxable income and this will have to be factored into the calculation to determine how much needs to be withdrawn to meet the amount required.

Reclaiming tax overpayments

For most clients, being taxed on the emergency tax code basis will result in an initial overpayment of tax.

Single or ad-hoc payments

Clients can reclaim any overpayment of tax from HMRC using one of the following forms - depending on their circumstances:

• Form P50Z - For full pension fund withdrawal and the client has no other PAYE or pension income (other than State Pension), or
• Form P53Z - For full pension fund withdrawal and the client has other employments or pensions
• Form P55 - For partial pension fund withdrawal and the client doesn't plan on taking a further payment in the same tax year from the same scheme

Where clients make a partial withdrawal, but plan further ad-hoc withdrawals later in the same tax year, HMRC will give the provider a tax code to apply to the next payment - this aims at ensuring the correct tax deductions are made up to that point (i.e the date of that payment). This should facilitate any appropriate refund of tax overpaid from the first payment.

Where no further payment is taken in the tax year, HMRC automatically review the individual’s tax position after the end of the tax year. They will then issue a tax calculation to the individual confirming any overpayment or underpayment of tax.

There is nothing to stop an individual submitting a tax reclaim after each withdrawal. But this obviously increases the level of administration involved in completing the relevant form on numerous occasions in the same tax year.

Regular income

On the setting up of the annuity or scheme pension, or on making the first regular drawdown income payment, the pension scheme provider will inform HMRC.

This highlights the member’s new income stream and should trigger HMRC to send back a tax code relevant to that individual’s tax circumstances.

HMRC can use different codes as a way of remedying any unresolved income tax issues the individual may have – either to ‘refund’ previous overpayments or collect any outstanding tax due in that same tax year.

Whether the tax code fully corrects the tax position can depend on how late in the tax year that regular pension income begins.