Pensions taxation issue not fixed yet

Exuberant headlines followed HMRC’s January pension schemes newsletter as HMRC finally appeared to be taking steps to ensure pension withdrawals are taxed correctly. The change being made is welcome, and will improve the situation for many, but I’m keeping my celebrations on ice as the biggest issue is still unresolved.

At the heart of the pension over-taxation issue is the fact that HMRC insists that pension providers apply the relevant tax code to the first pension withdrawal on a “month 1” basis. This is irrespective of whether it is an emergency tax code used (which applies in most cases), or if the member has provided a current year P45.

When a payment is made on the month 1 basis, the member will be taxed on that pay period only. Effectively this means that each month is treated discretely, with a twelfth of the personal allowance and each tax band applying. It does not make any difference when in the tax year the payment is made – it will be treated the same whether paid in May or March.

This means that if the member is starting regular income withdrawals the first payment is still likely to be overtaxed (with the exception being if they start their regular monthly income at the start of the tax year). Under the current process pension scheme administrators inform HMRC when the first payment is made, and HMRC then issues a new tax code which can be applied to subsequent withdrawals in the tax year. This will then correct the tax position over the year as the further payments will be taxed on a cumulative basis considering any overpayment in the first month.

The announcement in the January newsletter will improve this process. From April HMRC will automatically update the tax code after the first payment without the need for the scheme administrator to separately notify them. The notices for new tax codes will be automatically adjusted, so the corrections for subsequent withdrawals in the tax year should be made more quickly. There is no doubt this improvement will lead to a reduction in queries.

However, the big issue with over-taxation is for those pension members who make one-off withdrawals.

Under the old capped drawdown rules, HMRC permitted pension scheme administrators to apply the relevant tax code – be that the emergency tax code, or taken from a current year P45 – on a “month 12” basis where the member had stated it was the only withdrawal they intend to make in the tax year. Unfortunately, when pension freedoms came along, this more pragmatic approach was not permitted for flexi-access drawdown or uncrystallised funds pension lump sum payments.

When tax codes are applied on a “month 12” basis the full annual personal allowance and tax bands are available in relation to that payment. This means that when there is only one withdrawal made in the year, the tax will be correct without the need for re-adjustment.

HMRC’s view has been that there is a risk that if payments were made on this basis, and then a further withdrawal was made in the tax year, then there would be an underpayment. This is possible but would be rare if it was clear at outset that the intention was a single payment; and schemes could give appropriate warnings about the consequences of further withdrawals in the same tax year. It also makes little sense when you consider that members can make in-year reclaims (via forms P53Z, P50z or P55), and by the same argument still make withdrawals having stated that they won’t. When you consider that members may also be taking the payment at the end of the tax year, and / or emptying their pension fund, then using a month 1 basis makes even less sense. In the last quarter of 2024 alone nearly £50million of overpayments were repaid via over 14,500 forms.

Where members are wanting to take a one-off payment, where possible it can make sense for them to take a small withdrawal first. This will trigger the cumulative tax code which can then be used for the larger “one-off” payment.

However, we are no closer to solving the issue for those that need to take a lump sum payment at short notice for an immediate need. For example, if the member needs a £40,000 net payment urgently, under the current rules they would need to request a withdrawal of £70,000 to receive £40,069 after tax based on a month 1 basis. If tax were applied on a month 12 basis the gross withdrawal would only need to be £46,860 to receive £40,002.

Although they can reclaim the overpayment of just over £23,000, this money goes back to them personally. They cannot simply return it to the pension as they will have triggered the money purchase annual allowance, and in many cases may not have earnings to support further contributions.

The fact that HMRC is making improvements is welcome, but let’s hope that further changes come soon to make a real difference.