Hidden tax risks of raiding the pension pot

July 4, 2020 - 7 minutes read

Extracting cash from your pension might seem an obvious source of income during the Covid-19 crisis, but complex tax rules mean it should only be a last resort

As the lockdown has devastated parts of the economy, many will look to access longer-term savings to bridge their income gap. For those aged 55 and over, who can flexibly access pension savings, this may seem an obvious choice.

Yet hidden tax traps lie in wait for those who do so without taking financial advice. In 2020, more than 900,000 individuals will reach age 55, a trend that is set to continue, so questions about how to access pensions are likely to rise.

Money can be withdrawn from a pension without incurring any tax liability and most savers are familiar with the concept of a tax-free lump sum. But any balance withdrawn is subject to income tax and few understand the detailed rules.

This can leave savers with larger tax bills than anticipated and questions about how much overpayment of tax which can be reclaimed and the restrictions on future tax-relieved pension savings.

So, how can funds be withdrawn without destroying retirement savings and what are the tax traps to avoid?

Money Purchase Annual Allowance

Chief amongst these is the Money Purchase Annual Allowance (MPAA), which restricts future tax-relieved pension savings to no more than £4,000 a year once a pension pot has been flexibly accessed and any amount over the 25% tax free cash amount is withdrawn.

This restriction comes as a nasty shock to those who thought they could withdraw funds from their pension for short-term needs and rebuild their savings later. This rule was designed to prevent savers from taking advantage of pension freedoms by taking money out of their pensions and recycling it back in to claim a second slice of tax relief on the same money.

The MPAA was originally set at £10,000 in 2015/16 but reduced to £4,000 from 2017/18 and applies retrospectively to those who triggered the MPAA in earlier years. Any pension savings made above the £4,000 limit, including employer contributions, are taxed at the saver’s income tax rate, cancelling out the benefit of tax relief on that element of their pension savings.

Once the MPAA is triggered, the saver also loses the right to carry forward any pension savings relief not used in the three earlier years, placing another barrier in the way of rebuilding retirement savings. Complex rules mean that some withdrawals do not trigger this restriction, while others do.

Withdrawals of cash from a pension fund will not trigger the MPAA if:

Only the pension commencement lump sum is withdrawn, commonly known as the tax-free lump sum. The balance of the fund remains invested.

The lump sum is taken with the rest of the pension fund paid out as guaranteed lifetime annuity or an occupational pension (final salary or another scheme pension)

The whole pension fund is cashed in, but the pot value is less than £10,000. Up to three small pots may be withdrawn in this way during a lifetime. These small pots are also exempt from the lifetime allowance, so long as the saver has some lifetime allowance left when they are withdrawn.

Taxation of Income Withdrawals

Pension schemes are obliged to tax sums withdrawn in excess of the tax-free lump sum under PAYE on a month 1 basis and usually applying an emergency code. This is the case even where the taxpayer is only taking a one-off sum.

So, a £20,000 withdrawal where £5,000 is a tax-free lump sum and £15,000 is taxable income will be taxed as though 12 x £15,000 is to be paid in the tax year with 45% tax deducted from part of the payment.

If left uncorrected, loss of personal income tax allowance, together with knock on consequences for eligibility for tax-free child benefit and savings allowances also follow from this. The impact will reduce considerably the cashflow benefit of the withdrawal being taken from the pension scheme, with many unadvised taxpayers not being aware of how tax is applied or that they may have been overtaxed.

Taxpayers can claim a refund by completing a form P55 for partial encashments, P53Z for whole encashments and P50Z where the whole pot is taken but there is no other income, or via self-assessment at the end of the tax year.

So far, HMRC has refunded £600m of overpaid tax since 2015, but HMRC does not know how many taxpayers have been taxed incorrectly but not yet made a claim, so millions of pounds more could be owed.

Universal Credit

Those who are unable to work due to Covid-19 or qualify for various government income support schemes may be eligible for Universal Credit once their savings fall below £16,000. Money invested in a pension scheme by those under state pension age does not count towards this limit, but cash withdrawn from it will. Withdrawing cash from a pension may therefore disqualify the claimant from making a Universal Credit claim.

Ideally those in financial hardship due to Covid-19 should turn to their pension schemes as a last resort. Taking money out of a pension too soon can derail long-term retirement plans.

Given the tax privileges inside the pension wrapper, largely tax-free growth and the potential to pass funds not drawn on death to future generations, outside of the taxable estate, only taking what is really needed for immediate needs must be the best policy.

Contact MCL Chartered Accountants today on 01702 593 029 to optimise your tax position.