The past couple of years have been growing steadily tougher to cope with financially, and the majority of people have dipped into their financial reserves. Unfortunately, some have depleted them. One of those ‘reserves’ is a pension fund, and many citizens utilised their pensions for plugging income gaps.Long-term, dipping into your pension is something that you will learn to regret when experiencing the lack of a salary and the accelerating medical bills of retirement. The short-term impact of this pension-dipping could be a whopping tax bill.Let’s look at what you can do to avoid paying tax on your pension unnecessarily.
Tax pitfalls to avoid.
What tax relief entitlement do you have?
The general advice from finance or wealth consultants is that people who have investments in pension schemes, or indeed any finance vehicle, must have a firm understanding of the pension scheme or finance vehicle and the details of tax relief concessions applied to it.
If you are a young working citizen who is over the age of 22 years and you are earning £10,000 or above, you will have automatically have been enrolled by your employers into a pension scheme. This pension scheme might have:
Been chosen by your employer.
Been part of a shortlist given to you, and you were asked to choose one.
Been one that is run by the employer, i.e. an in-house pension scheme.
You will see a deduction from your monthly payslip contributing towards an overall amount of eight per cent (minimum) of your earnings. This is a worthwhile investment for your future retirement. The monthly contributions will consist of a four per cent contribution from you, a three per cent contribution from your employer and a one per cent contribution from a ‘Government top-up’, otherwise known as tax relief.
When these contributions are deducted from your gross salary, i.e. before the application of tax, then no action is required on your part as the pension scheme will be receiving a gross amount with zero tax deducted, i.e. a tax-free amount. Having gross amounts paid automatically boosts the value of your pension immediately by twenty per cent, and that is before looking into investment growth percentages.
If you are investing into a personally chosen investment fund (self-invested personal pension – Sipp) and the deductions from your payslip are made after-tax has been applied, then you will most likely have to reclaim an additional rate of tax.
Here is an example of the above transaction:
You have a personally chosen retirement investment scheme called AB. For example, if you execute payment of £80 into your self-invested personal pension (Sipp), it will immediately be increased to £100 (twenty per cent) regardless of how much income tax you were paying at the time. If, however, you are a higher-rate taxpayer, you could therefore claim back an additional £20. A claim of £25 extra could be claimed by an additional-rate taxpayer.
This claim can be submitted via a self-assessment tax return or simply by phoning HMRC. This has to be repeated every year and, by doing this, you are also making sure the correct, adjusted amount of tax relief is given to you. This claim must be made annually, even if you are getting an annual allowance charge.
If you are having an ‘Oops-I-haven’t-done-it” moment, then fear not. You can action these claims retrospectively up to four years back.
When the vast majority of people hit hard times, one of the first things to get slashed from their budgets is pension contributions. Choosing these contributions as one of the top priorities to discontinue is a double-edged sword. Not only does your pension maturity value shrink, but you lose the advantage of using the greater buying power of the contributions. Due to the volatile market conditions, the greater buying power is due to the pound-cost average being affected. In plain English, this means that the share prices have dropped, so if you make your contributions, your pension fund can buy more shares for the same monthly amount. When the market stabilises and indeed hardens, you will see accelerated growth in your pension maturity value.
Experienced financial advisors and wealth consultants will generally agree that the mixture of tax-free cash from age 55, tax relief, and an employer matching employee contributions is a solid, to-notch investment vehicle. It is very difficult to find another product to compete against that combination. If you add the power of keeping contributions going during volatile times, then you will be sitting pretty at retirement time.
The tiring and financially stressful two years we have all been through may have resulted in some people losing their employment and having to scramble for a lower-income job. This is one of the prime triggers for cancelling contributions to pension schemes. This is a huge waste of capital momentum that you have built within that scheme and, to top it all, you might not be able to re-join it later. You also lose matching contributions from your employer and the Government. Cancelling contributions should be much lower down the priority ladder.
There are tax relief incentives for prudent citizens who are savers. The Government has set an annual tax-free allowance of up £40,000 of funds being paid into a person’s pension annually. Whilst this is beneficial, it has sadly been worn down since 2010 when it stood at £255,000.
To keep things positive, it should be acknowledged that £40,000 is still double the Isa allowance.
Carry forward rules
Financial consultants are advising clients to be aware of carry-forward rules for pension contributions. The pension scheme’s carry forward rule gives you the flexibility to use any unused allowances, of up to three years, all at once in the current tax year. As an example:
If you froze all your pension contributions in 2019, 2020 and 2021, you can carry forward 3 years’ worth of unused allowances, viz. £120,000. You would then add this to the £40,000 allowance of 2022, giving you a total of £160,000 tax-free savings.
This flexibility is excellent news for those who want to catch up on their retirement savings.
This tax-free allowance is not the same for everyone as those citizens earning more than £200,000 might have their allowance reduced to £10,000 under tax taper ruling relating to pensions schemes.
Pension freedoms trap
As we mentioned at the beginning of the article, when hard times hit, you might be tempted to dip into your pension in order to bridge the income gap. If you are over the age of 55, then you must be very aware of the tax implications of this ad-hoc dipping.
Most people are aware of the pension freedom legislation that was passed in 2015. This was welcomed by early retirees as, from the age of 55 years, they were now allowed to dip into their pension pot without being taxed. Hundreds of thousands of citizens over the age of 55 have jumped at this opportunity annually and have enjoyed the tax relief on the twenty-five per cent lump sum.
The trap and its trigger
The ‘trap’ that we mention in this paragraph title occurs when you pay into the pension scheme after taking out your lump sum. The withdrawal of savings from some pension schemes can trigger a ‘money purchase annual allowance’. What that actually means is that when you pay funds back into the pension scheme, your tax relief allowance is reduced from £40,000 to the very small amount of £4,000!
You also lose the flexibility of the carry-forward rule, and any unused allowances from the past three years also fall away. This was unfortunately brought about by the Treasury due to people abusing the system. The pay-in and withdrawal relief was being used to recycle substantial amounts through pensions to get extra tax-free cash.
The decision to ponder, when considering accessing your pension funds but fearing the activation of the ‘money purchase annual allowance, is whether the withdrawal of the tax-free lump sum will be sufficient to meet your needs. For example, are you planning a once-off purchase, or is this withdrawal going to be a regular occurrence?
Monitor lifetime allowances
We have discussed a few allowances thus far, and there is another one that you need to keep your beady eye on. This is the lifetime allowance. Whilst saving is encouraged, the Government changes its attitude when ‘significant wealth’ starts to be accumulated.
Financial consultants advise that astute savers should monitor the overall size of their capital within the pension scheme. If you had a cracking good saving history and your pension plan is now exceeding £1.073 million, then you have crossed the lifetime allowance threshold. The benefits from this pension scheme will be taxed at fifty-five per cent if it is paid out as a lump sum. If, instead of a lump sum, you need or want to withdraw a regular income from the fund, then each withdrawal will attract a taxation rate of twenty-five per cent each time a withdrawal is made.
The financial experts advise that you should not suddenly change your investment strategy if your pension plan has exceeded the lifetime threshold amount. The ongoing growth that will be achieved on the amounts over the lifetime threshold will be still highly advantageous to you. What you should discuss with your wealth professional is the point at which you should cease contributions and direct them to another investment vehicle so as not to waste your tax relief.
Emergency tax codes
A retrospective review was conducted, by a group of accounting professionals, on the withdrawals from pensions done over the past 2 years by citizens over the age of fifty-five years. These citizens were under severe financial pressure and dipping into their pensions for the first time to resolve the unexpected income gaps caused by the global economic stress. It was found that the majority of them were erroneously overtaxed by thousands of pounds under the heading “emergency tax”.
This resulted in a massive reclaim of taxes by pension savers against the HMRC. The resulting astonishing amount totalled more than £125 million in pension tax. That figure was just for 12 months of 2020. It is estimated that the average pension saver was overcharged more than £3,213 for the annum – not an amount to be scoffed at.
Month one tax
When a pension saver makes their very first withdrawal from their pension savings, it triggers an automatic emergency “month one” tax from HMRC as the system sees the transaction as a single withdrawal of many. The assumption that the HMRC algorithms make is that when a large withdrawal is made in one month, it is assumed, albeit incorrectly, that the amount is to be the monthly income that would be withdrawn every month across the entire year. The system then calculates and applies what ‘relevant’ tax rate. In money terms, this means that if you withdraw £10,000, this is viewed as one withdrawal of 12 withdrawals, and you are therefore taxed as if you had earned £120,000 that year.
Tax consultants have advised that this happens when the pension scheme administrator does not have a tax code for that particular pension saver in that specific year. The unfortunate pension saver has to wait for their HMRC end-of-tax-year reconciliation. They can also proactively reclaim the tax overpayment if they have noted it. Many people who were acting independently without the guidance of a financial or wealth consultant were very shocked and panicked.
Reclaiming tax fast
One way to speed up the refund of your erroneously charged tax is to fill out a mini tax return. There are three forms that you can consider using, and they are:
The “P55” form – this option is for people who have made a partial cash withdrawal from their pension.
The “P53Z” form – this option is for people who have made a withdrawal of the entire pension as cash and are still earning an income.
The “P50Z” form – this option is for people who have made a withdrawal of the entire pension as cash and have stopped working.
This mini tax return system was created by the HMRC to assist pensioners who need to claim their money back in the middle of the tax year. The HMRC is cognizant of the delicate balance of cash flow in our retirement years, and they have, therefore, committed to paying out such refunds within 30 days of official receipt of the forms.
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