Pension withdrawals - how is emergency tax rate calculated?

[charcinders]

I'm a sole trader and my business is my only income source. I'm about to withdraw some money from my private pension for the first time. I understand that 25% of this is tax-free and tax on the rest is charged at the emergency rate. According to the advisor I just spoke to at the pension company this could be "up to 45%", but she couldn't explain how the rate will be decided.
So my question is: who decides, and on what basis? I'm guessing the answers are "HMRC" and "my average declared income". Is that right?

 

[DontAsk]

I would expect your pension company to do the calculation based on your tax code.

 

[charcinders]

I would expect your pension company to do the calculation based on your tax code.

That would be the logical way to do it... For some reason the pension company cannot do this. If I understand it correctly it is like starting work for a new employer who doesn't have a tax code for you so they apply the emergency code in calculating your first PAYE contributions. This is only the case for the first withdrawal; in subsequent withdrawals they have the correct code and can apply it.
However, there are different emergency codes for different income bands. This doesn't make any sense to me because to decide what emergency code to apply they'd need to know your income, but if they know your income why do they need an emergency code..?

 

[WaveJumper]

Yep as above thats just how they work it out, the first payments will be on an "emergency code of some sort" the pension company should be able tell you what this is going to be although they are not going to know your overall income. Certainly with my HMRC account when I then log in I see whats going on, dear old HMRC have looked at all other income streams then applied new codes depending on the various income streams, you may find they adjust the code on a larger amount leaving a lesser one untouched but your overall income will be taxed at the correct rate.

If you're married don't forget to make use of any allowances there.

Oh and hopefully Capita are not involved in any shape or form

 

[Newchodge]

That would be the logical way to do it... For some reason the pension company cannot do this. If I understand it correctly it is like starting work for a new employer who doesn't have a tax code for you so they apply the emergency code in calculating your first PAYE contributions. This is only the case for the first withdrawal; in subsequent withdrawals they have the correct code and can apply it.
However, there are different emergency codes for different income bands. This doesn't make any sense to me because to decide what emergency code to apply they'd need to know your income, but if they know your income why do they need an emergency code..?

My undersanding is that all of your withdrawal above 25% is taxed without any tax free allowance. If the amount exceed the higher earnings rate it is taxed at the higher rate, if below it is taxed at the standard rate. You declare the income and tax on your self adssessment and the tax is then corrected, if necessary.

 

[GLAbusiness]

I've been through this process. The pension company took the emergency rate tax and issued a P60. Then the correct total was all sorted out on my self assessment return.

 

[charcinders]

I've been through this process. The pension company took the emergency rate tax and issued a P60. Then the correct total was all sorted out on my self assessment return.

Yes, that much I already knew (apart from the P60). What I don't know is what emergency tax rate they will apply and how they will decide. All they would tell me was "It could be up to 45%", which seems like an uncharacteristically vague statement for a financial institution to make.

 

[GLAbusiness]

For me they used code SD1 (the S denote Scotland)

 

[NewKidinTown]

Depending on the amount of the retirement fund and your personal tax allowance what you will end up with is a blended rate (a mixture of 20%, 40% and 45% rates) i.e. the rate applied could be 45% on a portion of the fund.

Because the payment is treated as a month 1 (emergency basis) payment the bands for the tax rate will be divided by 12 and the rates applied to these smaller bands. Thus although the 45% rate starts on annual income of £125,141, this is £10,428 as a monthly figure.. Therefore even a modest payment could be taxed at the additional rate of 45%. A repayment of the overpaid tax can be obtained from HMRC

Example (for illustration only - figures rounded for brevity)

Pension company pay-out of £20,000

tax free 25% £5,000

net £15,000

personal allowance (£12570 / 12) = £1,048

taxable £13,952

basic rate (first £37,700 / 12) = £3,142 @ 20% = £628

higher rate ( [37,700 £125 140] / 12) = £7,287 @@ 40% = £2,915

additional rate ( [15,000 - 3141.67 - 7286.67) = 4572 @ 45% = £2,057

so in summary

retirement fund £20,000
tax free £5,000

taxable £15,000
tax deducted £5,600 (blended rate of 37.3%)

net receipt (£5,000 + £15,000 - £5,600) = £14,400

 

[MikeJ]

deleted this, as I missed the point.

 

[charcinders]

Depending on the amount of the retirement fund and your personal tax allowance what you will end up with is a blended rate (a mixture of 20%, 40% and 45% rates) i.e. the rate applied could be 45% on a portion of the fund.

Because the payment is treated as a month 1 (emergency basis) payment the bands for the tax rate will be divided by 12 and the rates applied to these smaller bands. Thus although the 45% rate starts on annual income of £125,141, this is £10,428 as a monthly figure.. Therefore even a modest payment could be taxed at the additional rate of 45%. A repayment of the overpaid tax can be obtained from HMRC

Example (for illustration only - figures rounded for brevity)

Pension company pay-out of £20,000

tax free 25% £5,000

net £15,000

personal allowance (£12570 / 12) = £1,048

taxable £13,952

basic rate (first £37,700 / 12) = £3,142 @ 20% = £628

higher rate ( [37,700 £125 140] / 12) = £7,287 @@ 40% = £2,915

additional rate ( [15,000 - 3141.67 - 7286.67) = 4572 @ 45% = £2,057

so in summary

retirement fund £20,000
tax free £5,000

taxable £15,000
tax deducted £5,600 (blended rate of 37.3%)

net receipt (£5,000 + £15,000 - £5,600) = £14,400

Thank you for your detailed explanation. If I understand it correctly, the withdrawal is taxed as if it was my monthly salary - as though I will be making another 11 withdrawals of the same amount during the financial year.

 

[Newchodge]

Thank you for your detailed explanation. If I understand it correctly, the withdrawal is taxed as if it was my monthly salary - as though I will be making another 11 withdrawals of the same amount during the financial year.

I am not convinced that is right for lump sum withdrawal. It is probably right for receiving a monthly pension.

 

[DontAsk]

I am not convinced that is right for lump sum withdrawal.

It's what I have read elsewhere. It results in people paying a lot more tax than they expected and then having to wait for a refund.

 

[WaveJumper]

You might find this useful - scroll down to the emergency tax on withdrawals

Pension tax calculator - Which?

Learn about how different sources of retirement income are taxed, and use our handy calculator to work out how much you'll have to pay.

www.which.co.uk

 

[charcinders]

You might find this useful - scroll down to the emergency tax on withdrawals

Pension tax calculator - Which?

Learn about how different sources of retirement income are taxed, and use our handy calculator to work out how much you'll have to pay.

www.which.co.uk

That was indeed useful, it says I'll only be taxed at 20%, which is nice.

I also see this: "If your pension provider already knows your tax code for the year, and the correct amount of personal allowance you should receive, it can use this instead of an emergency tax code. This means that there is less risk of overpaying tax and having to claim this back."
I don't understand why they didn't just ask me what my tax code is rather than being vague about it, but I'm sure they have their reasons.

 

[GLAbusiness]

I am not an accountant, but what I think is:

If you have other income apart from the pension draw down then you tax code will determine the tax on your other income, taking your personal allowance etc. into account. In this case the tax on the drawdown would be at a rate determined by the tax band you are already in for your other income. So, the pension company does not have the information needed to deduct the correct tax - they would need all the detail of your tax return to do this. So, they apply a rate which means they won't lose out and you may be able to cliam an adjustment on your self assessment