Clients who took an uncrystallised funds pension lump sum payment could be owed thousands of pounds on overpaid tax, as Tom Selby explains.
If your clients made a single ad-hoc withdrawal from their retirement pot from age 55 following the introduction of pension freedom two years ago, they may well have been overtaxed by thousands of pounds.
The tax quirk people need to be aware of is most likely to affect those who take a single uncrystallised funds pension lump sum (UFPLS) payment in a given tax year. Tens of thousands of savers are already likely to have accessed their fund in this way, while anyone planning on making a withdrawal could be affected.
Those who are taking a regular monthly income from their fund, either through flexi-access drawdown or an annuity, should be taxed at the correct rate.
How does it work?
When your client accesses their pension pot through UFPLS, they will get 25% tax-free and the remaining 75% should be taxed at their marginal rate of income tax.
For example, if someone makes a £13,333 UFPLS withdrawal, £3,333 (25%) should be tax-free and the remaining £10,000 taxed at their marginal rate. Given that the personal allowance for 2017-18 is £11,500, if your client had no other income the entire withdrawal should be tax-free.
Many savers will have already been left confused or angry – or both – after finding a large chunk of their withdrawal has disappeared to the taxman.
This is because HM Revenue & Customs (HMRC) rules mean that in most cases pension providers will tax a single UFPLS withdrawal on a ‘Month 1’ basis. Under Month 1, your client’s total tax allowances for the year are divided by 12, and then the tax is taken off their pension withdrawal.
The result? Rather than paying zero tax, the saver in the above example would be hit with a charge of more than £3,000.
Similarly, a £15,000 withdrawal would be overtaxed by more than £5,000, while a £40,000 UFPLS payment would be hit with a £16,000 charge – over £11,000 more than they should have paid (see table, below).
The actual tax paid will depend on any other sources of income your client has. It is also worth noting that the figures might alter for Scottish clients as tax bands are different north of the border.
But clearly failing to do the right paperwork – and it is onerous for anyone who does not have advice – can be extremely costly.
How to make a reclaim
As with many things tax-related, the solution is not straightforward. How to make a claim for any overpaid tax depends on the nature of the withdrawals and your client’s personal circumstances.
If the payment used up the entire pension pot and your client has no other income in the tax year, HMRC form P50Z needs to be filled out.
If the payment used up the pension pot and your client has other taxable income, HMRC form P53Z needs to be completed.
If the payment did not use up the pension pot and your client is not taking regular payments, fill in HMRC form P55. This form can be used only if the pension provider cannot process the refund.
HMRC says that, once they have received the relevant paperwork, the client will receive any tax due to them within 30 days – but it is up to the individual or their adviser to notify them using the relevant form.
Anyone who does not will be relying on the Revenue fixing the problem and there is no guarantee your client will get their money when they need it.
A possible solution
I understand why HMRC has taken this stance on single UFPLS withdrawals. By placing the responsibility for sorting out tax on the individual, it reduces its own administration burden and in the process boosts short-term tax revenues.
However, it seems grossly unfair to place all the responsibility on individuals who may think they are doing the right thing by keeping withdrawals below the relevant income tax band. This is particularly the case for basic rate taxpayers who are less likely to either have an adviser or any experience in filling out tax returns.
And there is a simple solution to all of this. For more than two decades HMRC, under capped drawdown, allowed withdrawals to be taxed on a ‘Month 12’ basis without any problems or complaints.
Reverting back to this system for single UFPLS withdrawals would be fairer and simpler for those the system is supposed to work for: savers.
Tom Selby is senior analyst at AJ Bell
The post Tax hit: Counting the cost of pension freedom appeared first on Retirement Planner.