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Tax 01 Purple

Tax Traps: Free your pension and avoid unexpected tax bills

3 min read
Daniel Wood, Financial Planner12 May 2021

An expression I like to use, so stop me if you’ve heard this one before, is ‘there is only one thing worse than a tax bill, and that’s an unexpected tax bill’ - a slight amendment from Oscar Wilde.

The pension freedom rules introduced six years ago aimed to give people more control over their retirement income, allowing pension savers who have reached the age of 55 to withdraw money from their pots whenever they like. Since 2015, the total value of flexible withdrawals from pensions has exceeded £45bn¹. But those who withdraw for the first time are in danger of being charged excessive amounts of tax at an ’emergency rate’.

Under the pension freedoms rules, savers who have reached the age of 55 are no longer required to purchase an annuity and can withdraw from their pension in small amounts or as a lump sum.

Let’s assume you have just retired, and you are looking to take some income from your pension – a one off £15,000 payment. Easy, you would think – ‘I can take some of it from the tax-free element of my pension ‘– the 25% pension commencement lump sum. So, 25% of £15,000 is £3,750.

This leaves the remaining £11,250, which would be taxed as income tax. But as it is below your personal allowance, you would assume there is no tax to pay. Wrong.

This £11,250 is treated as a monthly income and taxed via emergency tax. The pension company taxes you as though you are going to take this 12 times (as there are 12 months in the year), equivalent to an annual income of £135,000 (12 x £11,250). This income, in excess of £100,000, means you will have a lot more tax to pay, plus you will lose your personal allowance. So, your tax bill will be circa £6,000 on this £15,000 payment.

If this withdrawal was a one-off, in a particular tax year, you would then have to reclaim this overpaid tax via your tax return. So, if you needed £15,000, you would receive much less at the outset – nearer £9,000.

Now, in a different scenario, you have already taken £15,000 from your pension, are still working but phasing into retirement. Your company pays £40,000 into your pension. You think ‘how tax efficient – no tax to pay.’ Wrong again!

You have invoked the Money Purchase Annual Allowance (MPAA) – this means that because you have taken ‘income’ from your pension you will only get full tax relief on £4,000. There is no tax relief on the remaining £36,000 – so another unexpected tax bill awaits.

Circa 1,000,000 over 55s are at risk of an unexpected tax bill. If each of those takes £20,000 out of their pension each year and lands an unexpected 20% tax bill, this adds up to £4 billion in the Exchequer’s pocket. I’d like the interest on that for a year.

So, what are the options again?

Pension drawdown allows you to access your pension pot to provide you with a regular income. The income you get varies on your fund’s investment performance and, unlike an annuity, it isn’t guaranteed for life. However, it could be suitable if you want to have more control over how your money is invested. It may also benefit you if you want the flexibility of taking out different amounts during the year and want to manage your tax liability.

However, there are other things you need to take into consideration before withdrawing your money. If you want a guaranteed income for life, are concerned about running out of money or don’t want to expose your pension pot to investment risk, income drawdown may not be for you.

In this complex world of pension freedoms, the only solution is getting advice from people who know the rules and, more importantly, how they apply to you. So, to avoid contributing to the £4 billion tax bill, seek tax advice. It will be much cheaper in the long run.


The steps highlighted in this press release are intended as a general guide only. The information contained in this document does not constitute investment or tax advice. Tax rules are subject to change and taxation will vary depending on individual circumstances.

¹ https://www.which.co.uk/news/2021/05/hmrc-pays-back-716m-in-overpaid-pension-tax-are-you-owed-a-refund/

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