Pensioners are being told to avoid an unexpected HMRC tax bill – by spending £1. That’s because of rules around how tax on your pensions works which could land you with a bill from His Majesty’s Revenue and Customs.
Under current pension tax rules, you can withdraw from your private, workplace pension or SIPP once you reach age 55 (which is rising to 57 soon). This is not to be confused with the state pension, the benefit paid out once you hit state pension age. Although money you put into your pension is tax-free, cash you take out of your pension isn’t, and if you’re still working, you could actually end up with a significant tax bill because the money you take out of your pension can be taxed along with the rest of your earnings in a given financial year (April to April).
To get around this, you’re allowed to withdraw 25% of your pension tax-free when you retire.
If, for example, you had £200,000 saved up in your workplace pension, you could then withdraw £50,000 of it tax-free as a lump sum.
But the downside is that any money you withdraw after is subject to tax at your normal rate of income tax. When this happens, you could actually end up overpaying tax because HMRC may put you on an emergency tax code rather than the tax band you’re supposed to be in. This happens when HMRC does not have an up-to-date tax code for you, so it defaults you to a higher estimated rate.
As a result, you then receive a tax bill which is much higher than anticipated and it can take several months to claw the money back from HMRC after it’s been taken.
To avoid this, simply withdraw £1 from your pension. This will instantly trigger a tax code from HMRC.
Once you have the code, you can then withdraw more money from the pot and it will be taxed at the correct rate.
Money expert Martin Lewis has in the past talked about tax on pensions and how to avoid common pitfalls.
Speaking on his Not The Martin Lewis podcast – a spin off of his regular episodes in which he invites experts on to talk about specialist areas – he said: “The big thing to understand when it comes to taking money out of your pension when you’ve got a pot of money built up, a lot of what’s worth thinking about is tax.
“You generally get 25 percent of the money in your pension tax free, and the rest is taxed.
“But what counts and when it’s taxed is when it gets complicated.”
One method is to use a draw-down or annuity.
He said: “But if you do what’s called a draw-down or annuity then you can just take the jam, you can take 25 percent of your pension totally tax free and you’re paid the rest via the draw-down or annuity later when you take it.
“This allows you to control when you pay the tax on your pension pot. If later on in life you become a non-taxpayer, you take the rest out when you’re a non-taxpayer, you get a 25 percent lump sum now, and then when you take the rest of the money out even though it’s taxable, because you’re a non-taxpayer, it would be better for you.”
