Using pension drawdown in retirement offers lots of flexibility and the potential to keep your pension growing.
However, the tax on pension drawdown can get very messy. In many cases, HMRC tax the first pension drawdown payment incorrectly. Having to sort this out can kick start months of toing and froing with HM Revenue and Customs (HMRC). It can even mean having to take more out of your pension than you need so you can get the right amount after tax.
What happens to tax on pension drawdown?
There has never been an efficient way to tax the withdrawals from a pension pot. So, let’s look at the actual tax rules that apply to pension drawdown:
When you withdraw from your pension for the first time, usually up to 25% of your pension can be taken tax-free, with the remaining 75% subject to Income Tax.
You could decide to take only from the tax-free element, and you might withdraw some taxable income alongside this.
HMRC will add any taxable income you withdraw to any other income you receive and tax you accordingly.
So, someone earning £15,000 a year in gross rental income would pay tax at 20% on a £10,000 taxable pension drawdown payment. 20% tax equates to a tax bill of £2,000.
In theory, tax on pension drawdown should work like all other income subject to Income Tax. The reality is different, and there is a complex web of emergency tax codes used by pension providers. Pension providers use payroll systems to pay pension income out. These need to have a tax code input for each individual before they can pay money over. On the first drawdown payment, a pension provider will likely use some form of emergency tax code unless told otherwise. A potential effect could be a pension provider taxing a withdrawal on a “month one” basis. “Month one” taxation means you only get 1/12th of the personal allowance (£1,047.50), 20% bracket (£3,125) and 40% bracket (£9,375). Anything above this would be subject to 45% tax. Using the £15,000 withdrawal covered previously, “month one” taxation could result in paying over £3,000 more in tax than needed.
Even if you knew your tax code because you receive other income, this does not mean your pension provider has it. In addition, the additional income from your pension will probably mean HMRC will change the code. The worst part of dealing with tax codes is when someone urgently needs to take money out of their pension but must take much more than they need to due to paying the wrong tax.
How do I manage tax on pension drawdown?
As you can see, tax on pension drawdown is a complex area. Seeking professional advice is vital to ensure you don’t overpay tax and get stuck with persistent HMRC tax code changes.
Here are a few things you can do to make things easier:
Give yourself plenty of time to prepare for your first withdrawal from your pension.
Consider making a £1 withdrawal a few months before the withdrawal is required to trigger a tax code from HMRC. Having a tax code in place could prevent an emergency tax code from being applied to your first ‘proper’ withdrawal.
Keep an eye on your Government Gateway account, as this will let you know what tax codes HMRC assign to different income sources. You can then amend these via the site.
Reclaim any overpaid tax or pay underpaid tax as soon as possible rather than letting HMRC constantly adjust your tax code. These constant adjustments can lead to things getting very messy. Form P55 will allow you to claim overpayment of tax when you access your pension pot.
You will pay the right amount of tax in the end. It can be that, in the meantime, the system can cause a lot of hassle and unplanned withdrawals.