Navigating the taxation maze

You may have older workers within your organisation who are planning to take advantage of the new pension flexibilities and dip into their pension pot, regardless of whether or not it is prudent to do so. When they see just how much tax they will have to pay and how many hoops they will have to jump through, some are likely to think again.

The new pension freedoms have received a broad public welcome, but there are a number of factors that could put the purchase of that yacht, sports car or dream holiday on hold.

The biggest issue is that for most people still in work, withdrawing pension cash will mean paying more tax than they would if they wait until they retire.

While a quarter of the fund can be taken tax-free, the remaining three-quarters will be taxed at the individual’s marginal rate, as though it forms part of their annual income. That will push some people into a higher tax band, meaning they could be paying up to 45 per cent tax on the taxable element of their pension.

Wait until they retire and their tax rate will often be considerably lower, with some retirees paying no tax on their pension withdrawal at all. Or at the very least, workers should be considering taking withdrawals over a number of years to keep their tax bill as low as possible.

Pension scheme members with no P45 – for example former employees who are currently not working but not retired – may find themselves given an emergency tax code that assumes the amount being withdrawn is their monthly income. In a worst case scenario this could mean someone withdrawing a cash lump sum of £15,000 a year could be taxed at 45 per cent, because HM Revenue & Customs assumes they will take that amount every month for the rest of the year. They will be entitled to a rebate for the excess tax paid, but they may have to wait a year to get it, and they will have to fill in a tax return for the privilege.

Scheme members may also be confused by the mechanics of withdrawing cash. Workers wanting to withdraw only their 25 per cent tax free cash and leave the remaining three quarters within their pension are likely to be disappointed. This is because the vast majority of workplace pension schemes do not allow this. Instead withdrawals are made on the basis that a quarter is tax free and the remainder is taxed at their marginal rate. This type of withdrawal is called an ‘uncrystallised funds pension lump sum’ (UFPLS).

It is possible for employees to make a withdrawal of the tax free element only, but they will usually have to transfer to a different plan that offers income drawdown. Not only will they possibly find this difficult to arrange, but they will also have to pay charges that could run into hundreds of pounds to access a pension drawdown arrangement that allows them to do this.

Workers should also be made aware that they are also missing out on tax free growth when they withdraw their cash from their pension. Withdrawing it and leaving it on deposit with a building society makes no sense when you can benefit from tax free saving by keeping your money inside the pension wrapper.

The reality is that most people are going need as much money as possible to fund their retirement, so leaving it where it is makes sense. And for those contemplating making withdrawals against their own better judgement, the mechanics of doing so are likely to make them think again.

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