Using pension drawdown in retirement offers so much flexibility and the chance to keep growing your pension, however, the tax on pension drawdown can get very messy.
It’s highly likely the first pension drawdown payment you receive will be taxed incorrectly and this can kick start months of back and forwards with HM Revenue and Customs (HMRC) trying to get the right tax code applied and the right tax paid.
It can even mean the damaging consequence of having to withdraw more initially from your pension than you need, just to get the right net payment in your pocket.
What happens to tax on pension drawdown
The problem is, there has never been an efficient way to tax the withdrawals made using the pension freedoms features.
Please note this article relates to defined contribution pensions not defined benefit (final salary) pensions.
So let’s look at the actual rules that apply to tax on pension drawdown:
- When you withdraw from your pension for the first time usually up to 25% of your pension can be taken tax free and 75% is subject to Income Tax.
- You could decide to take only from the tax free pot or you could withdraw from both pots.
- If your withdrawal includes ‘taxable’ income from the 75% then the income you withdraw will be added on top of any other income you receive (e.g. salary, rental income, other investment income etc) and will be taxed according to the Income Tax band it falls in.
- So, if someone is earning £15,000 a year in gross rental income a £10,000 taxable pension drawdown payment will be taxable at 20% (£2,000) as it falls within the basic rate tax band.
So, in theory tax on pension drawdown should work like all other income subject to Income Tax, however the reality is far different and there is a complex web of emergency tax codes that can be used.
Your drawdown pension provider will use a payroll system to pay out your pension income and this will need a tax code before money is released.
On first drawdown payment, unless told otherwise, your pension company will likely use some form of emergency tax code.
For example, for a £15,000 taxable withdrawal, if you’re setting up a first withdrawal it may be taxed on a week one basis. This means you will only receive 1/52nd of the personal allowance (£241.73), 20% bracket (£725) and 40% bracket (£1917.86), with the rest taxed at 45%.
Even if you knew what your tax code was because you receive other income this doesn’t mean it will apply the correct tax on pension drawdown. The impact of the additional income from your pension will probably mean a change in tax code anyway.
The worst part of having to deal with these messy tax codes is that you may urgently require the funds from your pension drawdown. But if you are going to face a large tax bill initially it means you might need to take an even bigger withdrawal to account for the tax which means the bigger withdrawal will be taxed even more!
How to manage tax on pension drawdown
As you can probably see tax on pension drawdown is a complex area and I would definitely urge you to seek professional advice to ensure you don’t over pay tax and get yourself stuck with endless tax code changes from HMRC.
Here are a few things you can do to make things easier:
- Get organised – Give yourself plenty of time to prepare for your first withdrawal from your pension, understand your pension providers tax on pension drawdown policy so you can work out exactly what the tax will be and be ready for it.
- £1 withdrawal – Consider making a £1 withdrawal first in order to trigger a tax code from HMRC. This could avoid an emergency tax code being applied to your first ‘proper’ withdrawal.
- Use the Government Gateway – Keep an eye on your Government Gateway account as this will let you know what tax codes are being used for different sources of income. You can then amend these via the site.
- Deal with overpaid/underpaid tax in one go – Try to ensure that any overpaid tax is refunded or underpaid tax is paid in one go rather than allowing HMRC to constantly adjust your tax code to make up the payments. This gets very messy and can go on forever.
- Use P55 form to reclaim tax – Form P55 will allow you to claim overpayment of tax when you have flexibly access to your pension pot.
At the end of day the correct amount of tax will be paid and it will all come out in the wash. It’s just the time and hassle it takes to get there.
A big part of what we do as well as ensuring our clients have a sustainable income in retirement and an appropriately managed investment strategy is managing their tax position.
We ensure you keep as much of your pension as possible by ensuring withdrawals are tax efficient.
We also prepare all the necessary forms you need to complete your tax returns.
If you want to ensure you are not bogged down by taxes in retirement then please schedule a no obligation free 15-minute call.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.