Due to the coronavirus, many people’s incomes have been significantly reduced over the past few months and so taking money out of their pension pot may seem like a quick cash-flow solution. However, there are complex tax rules around pension withdrawals so people should be aware of the potential consequences.
While a tax-free lump sum can be withdrawn from a pension without incurring any tax liability, any balance withdrawn is subject to income tax.
Individuals can be left with large tax bills and confusion over how much overpaid tax can be reclaimed and the restrictions on future tax-relieved pension savings.
Money Purchase Annual Allowance
Once a pension pot has been flexibly accessed and any amount over the 25% tax free cash amount is withdrawn, the Money Purchase Annual Allowance (MPAA) is triggered and restricts future tax relieved pension savings to no more than £4,000 a year.
The MPAA was introduced to prevent savers taking money out of their pensions and then paying it back in to claim tax relief a second time on the same money, and means people withdrawing pension funds for short-term needs are restricted on the amount they can rebuild their savings with.
When the MPAA was introduced in 2015, it was set at £10,000 but this was reduced to £4,000 in 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. The saver also loses the right to carry forward any pension savings relief not used in the three earlier years.
The MPAA rules are complex and mean that some withdrawals do not trigger this restriction, while others do.
The MPAA will not be triggered by a withdrawal if:
- Only the pension commencement lump sum (the tax-free lump sum) is withdrawn and the balance of the fund remains invested.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 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 Up to three small pots may be withdrawn in this way during a lifetime.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pots are also exempt from the lifetime allowance, as long as the saver has some lifetime allowance left when they are withdrawn.
Emergency code taking on withdrawals
When withdrawing money from a pension scheme, the provider of the pension scheme is required to tax sums 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.
For example, 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.
The result is a loss of personal income tax allowance with other consequences including losing eligibility for tax-free child benefit and savings allowances, which will significantly reduce the cash-flow benefit of the withdrawal being taken from the pension scheme.
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.
Universal Credit may be available to those who are unable to work due to the coronavirus and do not qualify for the government’s income support schemes when their savings fall below £16,000. For those under state pension age, any money invested in a pension scheme does not count towards this limit, but cash withdrawn from it will. Therefore withdrawing cash from a pension may disqualify a Universal Credit claim.
Withdrawing money out of a pension too soon can significantly impact long-term retirement plans and should only be taken as a last resort.
Pensions offer many tax benefits including tax-free growth and the potential to pass funds not drawn on death to future generations outside of the taxable estate, so careful consideration needs to be given to withdrawing money early.