A Guide to Income Tax and your Pension Status
Do you want to make a withdrawal from your pension or significantly increase the withdrawals you are making from your pension? Withdrawing part or all of your pension benefits usually involves the payment of income tax.
Depending on the amount you withdraw and the way you take it, you could find yourself paying more tax and receiving less money than you expect. However, if you plan your withdrawals with this in mind, you can avoid this risk. The purpose of this page is to help you understand the possible tax due on your pension withdrawal(s), how the tax is taken, and where you can check that the tax is correct.
Tax matters can be complex and everyone’s tax position is different. Speak to PensionLite who can help you understand the implications of taking money from your pension.
For help please contact us telephone 01952 279 379 or email firstname.lastname@example.org
Answers to some common questions:
Your pension withdrawals: what’s taxable?
THE TAX-FREE ELEMENT OF YOUR WITHDRAWALS
Pension contracts normally allow you to take 25% of their value free of tax. As the term implies, this part of your pension is not liable for tax.
New rules introduced on 6 April 2015 allow you to take your tax-free allowance either upfront as a single tax-free lump-sum or as the tax-free portion of a number of withdrawals. In other words, you can ask for withdrawals with no tax payable on 25% of each amount and the remaining 75% will be taxable.
THE TAXABLE ELEMENT OF YOUR WITHDRAWALS
Whichever way you choose to take withdrawals, your pension provider will have to deduct any relevant income tax before making payments to you. The amount of tax payable on non tax-free withdrawals is calculated in the same way as the income tax paid on employment earnings.
All pension providers act as agents of HM Revenue and Customs (HMRC) and collect tax from your withdrawals in accordance with their instructions. The process used is the HMRC ‘Pay As You Earn’ (PAYE) system. It means that, from a tax point of view, you are effectively ‘on your pension provider’s payroll’.
YOUR TAX-FREE PERSONAL ALLOWANCE
The amount of tax you pay depends on how much your taxable income is above your tax-free personal allowance. This is the amount of annual income you can have before you pay tax.
HMRC calculates your tax-free personal allowance by taking into account your age and any entitlement to allowances or tax reliefs, less any deductions. They use this information to convert the result into a tax code.
Your tax code shows the amount of tax-free personal allowance you are entitled to. Many people receive taxable income from a variety of sources, for example bank deposits, investments, and several pension providers. HMRC considers all your sources of income and allowances to arrive at a tax code. As it is your personal financial circumstances that determine your tax code, it is unlikely to be the same as somebody else’s.
As explained in the previous section, tax codes are created by HMRC from your tax-free personal allowance. Your tax code tells your pension provider or employer how much tax to deduct. It is your responsibility to read the notices HMRC sends you to check that the tax due has been calculated using the correct information. Your pension provider will always inform you of the tax code used for any taxable payment made to you.
HOW DOES YOUR PENSION PROVIDER GET YOUR TAX CODE?
When first requesting income, if you send a P45 in respect of an employment or pension that terminated in the tax year in which the payment is requested, the tax code printed on it can be used. The tax code is then usually applied on what is referred to as a month 1 basis (please see page 6 for more information).
If your provider already hold a tax code for you, from a previous transaction, that can be used in respect of the payment you have requested.
If your provider does not have a tax code, they are required to deduct what is commonly known as ‘emergency tax’ which will more often than not result in an initial overpayment of tax.
HOW YOU’RE NOTIFIED OF YOUR TAX CODE AND WHEN IT CHANGES
You need to inform HMRC when there’s a change to your personal circumstances or taxable income which could affect your tax liability.
Failure to do so could result in you being on the wrong tax code. HMRC will calculate a new tax code if they are informed your circumstances have changed. For further details please visit www.gov.uk/tell-hmrc-change-of-details/income-changes.
HMRC usually posts your copy of the tax code notification to your home address, however from April 2015 HMRC has changed its process and will not always notify you if they think it will not have a material effect on the net income you are being paid. Pension providers usually receive their copy of your tax code electronically. They are not privy to the details of how your tax code has been calculated, nor will HMRC discuss your tax liability with them.
Providers are required by HMRC to submit details of your income paid, tax deducted and personal details every time they make you a payment.
From this information HMRC will know you are in receipt of pension income from ‘Your Provider’ and if applicable they will send them a revised tax code to be used in your next payment calculation.
YOU MAY HAVE DIFFERENT TAX CODES
Each payroll is identified with HMRC by their unique ‘Employer Pay As You Earn Reference’. For this reason you will have a different tax code for each employer and pension provider which pays you income.
A tax code for one type of income cannot always be applied to another even if the income you are receiving is from the same source.
For example, if you have a tax code which has been applied to lump sum payments you’ve taken from your pension, your pension provider may not be able to use this code for your regular income payments.
Understanding your tax code
Most tax codes are made up of a number followed by a letter. Some are just letters and some have a prefix letter then the number.
For example, if HMRC says you are entitled to a £10,600 tax-free personal allowance a year, they will divide this by 10 and issue a tax code of 1060. A letter at the end of your tax code is added according to your circumstances.
If your provider does not have a tax code when they make your first payment, HMRC dictates that they must use the current emergency tax code of 1060L M1 (this changes annually). The M1 indicates we are to deduct tax on a month 1 basis – see below.
L confirms you are entitled to the full personal allowance
P is the same as L but indicates that you are aged between 65 to 74 years old
N confirms a transfer of your personal allowance has been made to your spouse or civil partner
M confirms that you are a recipient of a personal allowance from your spouse or civil partner
V is the same as P, but you are also entitled to the married couple allowance
Y is the same as L but indicates that you are aged over 75 years old
T is normally referred to as a temporary tax code because HMRC is reviewing your tax code
K your deductions have exceeded your tax-free personal allowance
A few examples of tax codes:
1060L you are entitled to the full £10,600 annual tax-free personal allowance
BR all income is to be taxed at the basic rate (currently 20%)
NT no tax is to be deducted
D0 no tax-free personal allowance due, all income is to be taxed at the higher rate (currently 40%)
D1 no tax-free personal allowance due, all income is to be taxed at the additional rate (currently 45%)
0T no tax-free personal allowance due, all income is to be taxed at the basic, then higher, then additional rate accordingly
K953 your deductions have exceeded your tax-free personal allowance by £9,530
For further details please visit www.gov.uk/tax-codes/letters-in-your-tax-code-what-they-mean and www.gov.uk/tax-codes/overview
WHAT IS A MONTH 1 BASIS?
If there is an M1 at the end of your tax code then you are said to be on a month 1 basis. This means that your tax has to be calculated using only 1/12th of your annual tax-free allowance, in conjunction with the monthly tax bands, irrespective of the month your income is paid in.
For example, if your pension income is to be paid in September, which is tax period 6, you would only be entitled to 1/12th of your tax-free personal allowance rather than 6/12ths. The tax calculation to be performed must only consider the current income due to be paid; previous income must not be included.
It is not unusual for HMRC to send your provider a tax code for you on a month 1 basis. This means they will examine your tax liability and send them a revised tax code, or that they will re-calculate your tax liability at the end of the tax year. Any over or underpayment of tax will be identified and HMRC will notify you directly. If your tax code is on a month 1 basis, providers are not permitted by HMRC to rebate any overpayment of tax.
WHAT IS A CUMULATIVE BASIS?
If there is not an M1 at the end of your tax code then you are said to be on a cumulative basis. This means that your tax liability is recalculated from the beginning of the tax year (April) to the current tax period, every time it is paid, and any previous income paid within the tax year is taken into consideration.
For example, if your pension income is to be paid in September, which is tax period 6, you will be entitled to 6/12ths of your tax-free personal allowance, in conjunction with 6/12ths of the annual income bands.
Tax is due on all income that exceeds your tax-free personal allowance. The amount of tax calculated depends on your income, the HMRC income bands and the corresponding tax rates.
Tax rates (in other words, the percentage of tax you pay) don’t tend to change that often, however the income bands are usually amended each year. For published rates and bands please visit www.gov.uk/income-tax-rates
The current tax rates and bands for the 2015/16 tax year are:
|Tax rate||% Deduction||Annual income band|
|Personal Allowance||nil||up to £11,000|
|Basic rate||20%||£11,001 to £43,000|
|Higher rate||40%||£43,001 to £150,000|
|Additional rate||45%||over £150,000|
HMRC has supplied a tool which you can use to calculate the tax deduction we will make, you can find this at http://payecalculator.hmrc.gov.uk/.
PAYE and how it is administered
Income tax is an annual charge on your income. For employment and pension income it is collected at source under the pay as you earn (PAYE) scheme by HMRC. To avoid everyone having to submit a tax return to HMRC every year, the PAYE system is designed to deduct tax from income and pensions throughout the year, so that at the end of the tax year the tax deducted should be close to your tax liability.
Pension income is deemed a taxable income so providers have a legal obligation to deduct tax accordingly. Your pension provider is the agent of HMRC when it comes to operating PAYE. The tax deducted is dependent upon the tax codes provided to them by HMRC. If you feel the tax being collected is not correct tax you should contact HMRC.
PENSION PROVIDER PAYROLLS
To calculate and pay your pension income your provider will in most cases use ‘Monthly Frequency Payrolls’. This means that they process 12 pay runs a tax year. Your annual tax-free personal allowance is divided by 12 and if your tax code basis is cumulative, you will receive one month’s tax-free allowance per tax period to a maximum of 12.
However, many providers will use several different payrolls and which payroll is used for your payments may depend on your type of policy and the type of payment. For this reason you could be on more than one payroll system.
Your taxable income is the amount left after your provider has deducted your tax-free personal allowance. Then by applying the HMRC income bands and percentage tax rate, they know what tax to deduct.
The PAYE process assumes that the amount of money you receive each month is one twelfth of your annual income. If for example, you receive £24,000 a year in twelve equal monthly amounts, then each £2,000 instalment will be taxed at the appropriate rate, based on your personal tax code.
However, if you receive an extra payment of £24,000 on top of your monthly pay in July, for example,the PAYE system assumes that your income is going to be £26,000 each month for the rest of the tax year. The effect of this will be an overpayment of tax in July.
So, it’s important to understand that the timing of your withdrawal may affect the amount of tax you pay in that month, and in turn the amount of income you receive. This could affect your ability to meet your financial obligations at that time.
When are you sent a P45?
If you are provided with a P45, this is because your provider feels that they are making the final payment they expect to pay you under that payroll.
The P45 will show you how much tax has been deducted from your pension income within a tax year. If you have taken your full income withdrawal and have been sent a P45 you may have paid more tax than you should have. If there has been an overpayment, you should be able to claim a refund from HMRC using a process known as ‘in-year tax repayment’. If you contact HMRC they will review your liability, and may send a P50 or P53 form to complete.
The P45 is split into four parts, although you would normally only be sent parts 1A, 2 and 3. Part 1A is your copy to retain for future reference; please keep it safe as providers are not allowed to send you with a copy should you misplace it. Parts 2 and 3 of your P45 should be handed to either your next employer, pension provider or the jobcentre plus.
If you have only withdrawn part of your pension you will not be issued with a P45 until all your policy has been withdrawn. For this reason you will remain on your provider’s payroll. HMRC will be aware that you have had pension income payments as the details are sent to them every month. They will review your liability and send your provider a revised tax code to use if applicable.
Overpayments and underpayments of tax
Overpayment and underpayment of tax usually occurs because you have been on the wrong tax code or because your provider has had to use the emergency tax code in the absence of a P45.
If the PAYE regime results in an overpayment of tax, the overpayment will be taken into account by HMRC in their end of tax year reconciliation of your tax affairs. Similarly, if an underpayment occurs, this will also usually be taken into account by HMRC at the end of the tax year.
If you have not contacted HMRC within the tax year, their normal procedure is to automatically review your liability after the end of the tax year (5 April) and issue a tax calculation to you detailing any overpayment or underpayment of tax.
HOW TO GET YOUR TAX OVERPAYMENT REPAID TO YOU
You can claim a refund if you’ve overpaid tax in the current tax year or any of the previous four tax years. Please contact HMRC as follows:
Telephone: 0300 200 3300
Address: Pay As You Earn, HM Revenue and Customs, BX9 1AS, United Kingdom
Online https://www.gov.uk/claim-tax-refund/too-much-tax-taken-from-your-pay for full details of what you need to send HMRC to support your claim.
Payments from your account and their tax treatment
You now have a range of pension withdrawal options which you can use in a variety of ways to meet your needs. Not all of the following methods of withdrawing income are available from all providers. If you hold different pension contract you may need to consider moving them all to one provider. Please speak to PensionLite to find out what action may be appropriate.
1. PARTIAL OR TOTAL WITHDRAWAL OF YOUR PENSION ACCOUNT
When a payment is made to you, it may if you have requested this option, consist of two elements: a tax-free element and a taxable element. Normally the tax free element is 25% but in some circumstances it could be more or less.
The balance is subject to tax under the PAYE system. Providers will, in those circumstances, normally use an emergency month 1 tax code unless:
• Your provider holds a tax code for you in respect of a previous partial withdrawal or
• You have provided a P45 in respect of an employment or pension that has terminated in the same tax year as your payment is made, in which case the tax code on that form on a month 1 basis can be used.
Once the final payment is made from your plan you will be supplied with a P45 and advise HMRC. You should then be able to claim any overpayment of tax from them.
The tax code used and the timing of the withdrawal within the year can have a significant impact on the tax that is deducted.
2. REGULAR PAYMENTS FROM PENSION INCOME DRAWDOWN
These will be taxed under PAYE in a similar way to employment income. HMRC will supply providers with a tax code that tells them how much tax to deduct from each instalment of income.
When your first income payment is made your provider will have to use an emergency month 1 tax code unless you are able to supply a P45 from an employment or pension that ceased in that tax year. If you provide a P45 it can continue to be used on a month 1 basis until HMRC supply a different code.
The tax deducted on annual payments will depend on your tax code and the month in which the payment is made.
3. ONE-OFF PAYMENTS FROM PENSION INCOME DRAWDOWN
If you have previously been paid income from your pension account the tax code your provider holds for you can continue to be used. HMRC will reviews this tax code at least every year and supply you and your provider with an updated code if necessary. The amount of tax deducted could depend upon the month in which a payment is made and this may result in a larger deduction of tax than you expect.
If the payment is the first payment of income you have received your provider will have to use an emergency month 1 tax code unless you are able to supply a P45 from an employment or pension that ceased in that tax year. If your provider has a P45 it can continue to be used that tax code on a month 1 basis until such time as HMRC supplies a different code.
4. FINAL PAYMENT FROM PENSION INCOME DRAWDOWN
If you have previously been paid income from your pension account your provider will use the tax code they hold for you. HMRC reviews this tax code at least every year and supplies your provider with an updated code if necessary. The amount of tax deducted could depend upon the month in which a payment is made, and this may result in a larger amount of tax than you expected being deducted.
If it is the first income payment you have received your provider will have to use an emergency month 1 tax code unless you supply a P45 from an employment or pension that ceased in that tax year. If your provider has a P45 they can continue to use that tax code on a month 1 basis until such time as HMRC notifies them of a different code.
Once a payment has been made your provider will supply you with a P45 and advise HMRC. You should then be able to claim any overpayment of tax from them.
5. DEPENDANT/NOMINEE PENSION INCOME DRAWDOWN
If you inherit a pension account from somebody who has died, your withdrawals from that account will be taxed in one of two ways, as follows:
1. If the account was established before 6 April 2015, depending on the type of withdrawal you take, the tax treatment of your withdrawal payments will be the same as described in the sections above called ‘2: Regular payments from pension income drawdown’ and ‘3: One-off payments from pension income drawdown’.
This will also apply if the account was set up on or after 6 April 2015, and the person who originally owned the account died on or after age 75.
2. If the account was set up on or after 6 April 2015 and the person who originally owned the account died before age 75, no tax will normally be deducted.