Tabloid headlines suggesting that the freedom to withdraw pension savings after the age of 55 puts pensions on a par with bank accounts have been leading taxpayers astray.
A recent survey found that of 800 customers of a major life office surveyed, over two-thirds had drawn their whole pension pot as a lump sum and incurred unexpected tax charges.
When a withdrawal is made over and above the 25% tax-free cash entitlement, HM Revenue & Customs assume that similar sums are going to be drawn regularly in the future. So if £10,000 is drawn, this will be taxed on the assumption that £120,000 will be drawn over the course of the following year. This is known as the ‘month one’ basis of assessment and it applies even if the entire fund is drawn in a single payment.
It would have been understandable if the money released had been needed to pay off mortgage or other debts, but this accounted for only 16% of the withdrawals. In over 50% of cases, the pension holders had transferred the money to cash investments, such as bank or building society accounts, which are less tax-efficient than pensions, or into cash ISAs.
If the objective had been to reduce exposure on stock market volatility, transfers could have been made to deposit-based investments within the pension ‘wrapper’, and the tax benefits would have been maintained.
Anyone who has been taxed on a ‘month one’ basis can apply to HMRC for a refund. Three forms are provided, to cater for the circumstances of individual taxpayers.
A more satisfactory approach is for taxpayers to notify HMRC in advance of their intentions and to obtain a tax code which will then be used by the pension provider, who will deduct tax at the appropriate rate from each payment.
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