Use this '£1 trick' to dodge unnecessary pension tax
Savers are being forced to resort to a “£1 trick” to make sure they don’t get stung by emergency tax levied by HMRC on their pension savings.
Because of a quirk of the tax system, if you take a lump sum from your pension the tax man assumes this amount will be taken each month.
This “emergency tax” provision means pensioners only receive a twelfth of their “personal allowance” – the amount you can earn each year without paying income tax. The bizarre rules means Telegraph Money readers have in some cases paid thousands of pounds too much in tax .
Assuming no other income, a £10,000 withdrawal should be tax free because it falls under the personal allowance (£11,500 in 2017-18). But if HMRC applies emergency tax the bill would be over £3,000.
Paul Beardmore, 70, was shocked to discover he would have to pay hundreds of pounds in tax even though he only wanted to take two £1,500 lump sums from his self-invested personal pension (Sipp).
He said: “I’ve deferred taking my pension but about a year ago started looking in the mechanics of taking money out. I assumed you’d be taxed but when I saw I was going to be taxed at this enormous rate it was quite a shock.
“It seems funny to me that someone with a small pension pot would be assumed to be taking out the same amount each month. My provider also charges you each time you make a withdrawal, so I don't want to make as few withdrawals as possible.”
His provider, AJ Bell, has previously warned about the emergency tax issue but pension companies are powerless to stop extra tax being taken.
The tax office was unmoved even when Mr Beardmore explained to an HRMC adviser in an online chat that he wouldn’t be making monthly payments. The adviser refused to change the tax code to the correct one, saying it needed record of the payment from the pension company first.
Income tax has worked on this basis for decades but the “month one” problem has been exposed by the “pension freedoms”. These reforms, introduced in 2015, mean over-55s are free to take irregular withdrawals from their pensions whenever they like.
But financial advisers have realised that by making a small initial withdrawal you can avoid being caught out.
Chris Dando, of Burfield Financial Planning, said he found lots of his clients were not aware of the tax consequences of taking money from their pensions.
He said: “We are advising people take a nominal payment. The first payment is taxed on an emergency basis as if it’s a regular payment. So if we take an initial £100 or even £1 then HMRC will be aware and change the tax code accordingly.
“This ensures the correct tax code is used from the first proper payment. The only downside is that it slightly delays the process, as it may be another three or four weeks before the correct code is applied to future payments.
“So people who are desperate to get their money might be better off taking the money on an emergency basis and then claiming the rest back later.”
What if I’ve already been over-taxed?
Pensioners who have overpaid must either wait for HMRC to put them on the correct tax code or fill out one of three repayment claim forms.
There are three versions of these “mini tax returns”, depending on your circumstances. The “P55 form” should be used if you’re making a partial cash withdrawal. If taking an entire pension as cash, you must either fill in “P50Z” (if you’ve stopped working) or “P53Z” (if you’re still receiving earned or other income). You can fill out the relevant form online so long as you have a “Government Gateway” account, or by post.
If your pension provider has an up-to-date tax code from HMRC, or a P45 from the current tax year, from the employer you retired from, you don’t have to do anything.
The tax office promises to refund any overpaid tax within 30 days if the correct claim is submitted. In cases where taxpayers submit the wrong form or don’t realise they need to make a claim, they will eventually be refunded but HMRC will not say how long this could take.
A spokesman for HMRC said there was “no other option” than to apply the existing rules. He said if payments were made free of tax, the department would have to chase people for “large sums of tax”.
But Steve Webb, of Royal London, the pension company, urged HMRC to change its systems to “make life simpler for savers rather than simpler for the Government”.
He said: “It is useful for people to know that there are ways to avoid facing a huge up-front tax bill when taking advantage of the new pension freedoms.
“But it is also an absurd situation when people have to find ways to fight back when HMRC decide that they will simply take huge amounts of tax up-front and leave people to claim it back or wait for an eventual refund.”