A case study on emergency tax
This guide is for financial advisers only. It mustn’t be distributed to, or relied on by, customers. It is based on our understanding of legislation as at October 2023.
Registered pension schemes can make a variety of payments to different individuals. Some of these payments will be tax free but others will, in whole or in part, be subject to income tax. Depending on the circumstances, HM Revenue & Customs (HMRC) may require the scheme administrator (SA) to apply income tax using an ‘emergency tax code’. This can result in an overpayment or underpayment of tax.
‘Emergency tax code’ sounds quite dramatic but it simply means that whoever is making an income payment hasn’t been provided with a current tax code for the payee. Instead, they use a temporary tax code until HMRC determines the tax code which should apply to that particular individual. The emergency tax code will ensure that, at least, basic rate tax will be deducted from any payment, after taking into account a tax-free amount of £12,570.
The emergency tax code in 2023/24 is 1257, reflecting the basic rate tax threshold of £12,570; it will be followed by W1, M1 or X. The suffixes indicate whether the payment period is weekly, monthly, or non-standard.
This case study looks at when an overpayment of tax may arise and how the recipient can reclaim any tax due. It’s a simplistic example to illustrate how the emergency tax code works and it assumes the pension payment is the only income.
Alex has a fund of £170,000 in a SIPP. He gave up work recently, aged 64, but doesn’t need a regular income quite yet as his wife continues to work and he has some savings he can dip into as and when he needs to. Alex wants to take money out of his SIPP to pay for some home improvements. This will be his first withdrawal from the SIPP and he decides to take out £24,000 in the form of an uncrystallised funds pension lump sum (UFPLS).
25% of the UFPLS can be paid tax free. Alex has to pay income tax on the remaining £18,000. In the normal scheme of things, after deducting the £12,570 personal allowance, he’d expect to pay 20% tax (the basic rate) on the remaining £5,430. But if he’s expecting to receive a payment of £22,914, he’s going to be in for a surprise.
How does the SA apply tax?
The SA doesn’t hold a tax code for Alex so HMRC require them to apply the emergency tax code using the M1 – month 1 – basis. This means that the £18,000 taxable element of the UFPLS is treated as a regular monthly payment (even though the SA knows that it’s a one-off) and doesn’t take into account any income or tax that’s been paid to date. It’s this requirement to use the month 1 basis – imposed by HMRC - that gives rise to the overpayment of tax.
This would equate to an annual income of £216,000. Using the month 1 basis, the SA will deduct 1/12th of £12,570 from the £18,000 (equivalent to £12,570 from £216,000) and tax the remainder accordingly. Here’s how it works:
The first £12,570 is tax free. Tax is then applied at the following bands and rates as shown below:
20% on the next £37,700
40% on the next £87,440 (£125,140-£37,700)
45% on everything over £125,140
Taxable amount on month 1 basis
£12570/12 = £1,048
£37,700/12 = £3,142
£87440/12 = £7,287
(£216,000 – £137,710*) = £78,291
£78,291/12 = £6,522
Total tax deducted at time of payment
*£137,710 is the £12,570 tax free band plus the £125,140 upper limit on the higher rate tax band. Income above this level is taxed at the additional rate of 45%
So, the payment Alex receives from the SA will be £17,522 made up of a tax-free amount of £6,000 and a taxed amount of £11,522 (being £18,000 less £6,478 tax).
Note that the SA will be able to apply the correct tax code if one of the following applies:
- Alex has given them a P45 for the current tax year (eg, on changing jobs)
- Alex had already taken an income payment from the SIPP in this tax year – after the first payment, HMRC would have given the SA a tax code to be used for any future payments.
Note also that even if the SA held a current tax code for Alex, HMRC would still require that code to be applied to the UFPLS payment using the month 1 basis. The amount of tax that is deducted may still be incorrect, but HMRC will reconcile their records after the end of the tax year and will arrange for any under- or overpayment of tax to be collected or repaid. Each case will depend on the individual's own circumstances.
How much tax should Alex have paid?
For simplicity, assuming Alex has no other income, the personal allowance of £12,570 would be deducted from the taxable amount of £18,000 and 20% tax applied to the remainder. So the tax due would be £1,086. Alex’s £24,000 pension withdrawal would give him a payment of £22,914.
The SA will usually let Alex know how the UFPLS will be taxed so it shouldn’t come as a surprise when the payment is actually made. If Alex needs a specific amount of money in his hand, he has to be aware of how the benefit will be taxed so that he can work out how much of the pension fund has to be withdrawn to achieve this.
How will Alex claim back the overpaid tax?
Alex will be able to reclaim the overpaid tax by submitting form P55 to HMRC. This form is used when someone makes a partial withdrawal from their pension fund and doesn’t plan to make any further withdrawals in this tax year. Alternatively, he can wait until HMRC reconciles his tax records after the end of the tax year, when they will make any repayment due.
Having submitted tax to HMRC in respect of the UFPLS payment, HMRC will send the SA a tax code which will be used if Alex makes any further withdrawals. Alex should only submit a P55 if he doesn’t intend to make any further withdrawals from his SIPP in the current tax year.
If Alex had taken his full pension fund as an UFPLS payment, he’d submit form P50Z; this form is used where the taxpayer has no other source of income. If there was another source of income, form P53Z would be used.
- To illustrate the potential impact of applying the emergency tax code, the example assumes Alex has no other income.
- The example uses the tax rates and bands applicable in England and Wales; different rates and bands apply in Scotland.
You can read more about how payments from registered pension schemes are taxed in HMRC’s Pensions Tax Manual (under ‘Member benefits’ and ‘Death benefits’) and in their guidance to employers on PAYE.
Pensions Technical Services