Key points
- Single or ad-hoc payments, or initial payments of regular pension income, are normally taxed on the ‘Emergency month 1 basis’
- The emergency tax code will often result in an overpayment of tax - but for additional rate taxpayers, it could result in an underpayment
- HMRC forms can be used to reclaim overpayments of tax on single or ad-hoc payments.
- Regular withdrawals allows HMRC to provide relevant tax codes which may correct the overall position by tax year end
Jump to the following sections of this guide:
- Overview
- Emergency tax code – month 1 basis (M1)
- Meeting a short term need
- Reclaiming tax overpayments
Overview
When pension funds are crystallised, up to 25% of the crystallised amount can normally be taken tax free. Any payments from the balance are taxed as ‘non-savings’ income under the PAYE (Pay As You Earn) rules.
In practice, however, when a regular income starts to be paid (via lifetime annuity, scheme pension or income drawdown) or when ad-hoc payments are taken (via income drawdown or UFPLS), the amount of tax deducted will often be incorrect because the provider normally has to apply a temporary tax rate, referred to as ‘emergency tax’.
This applies not only to payments to the original member, but also to any taxable death benefits paid to beneficiaries, including taxable payments under inherited drawdown.
The emergency tax code will not be applied to payments made under triviality, small pots rules or winding up lump sums, as these are normally taxed at the basic rate.
Emergency tax code – month 1 basis (M1)
In the majority of cases, schemes paying out a single or ad-hoc withdrawal, or making the first payment of a regular pension, will use an emergency tax code on a month 1 (M1) basis.
This doesn't take into account any previous payments made in the current tax year. Income tax is calculated using 1/12th of the standard personal allowance and 1/12th of the basic rate and higher rate tax bands. Anything above that is subject to additional rate tax.
For many, this will result in an overpayment of tax. However, for some - for example, additional rate taxpayers - it could result in an underpayment.
The emergency tax code for the 2023/24 tax year is 1257L. This will give a tax-free amount of £1,047.50 (£12,570/12) and the rest of the payment will be taxable.
Example
Liam crystallises £40,000 in June 2023, taking tax free cash of £10,000, and drawing pension income of £30,000 under flexi-access drawdown. Using the emergency tax code 1257L M1, the pension income will be taxed as follows:
| Tax Band * | Amount for 1 month | Rate of tax * | Tax |
| Personal allowance | £1,047.50 | 0% | £0.00 |
| Basic rate | £3,141.67 | 20% | £628.33 |
| Higher rate | £7,286.67 | 40% | £2,914.67 |
| Additional rate | £18,524.16 | 45% | £8,335.87 |
| Total | £30,000.00 | £11,878.87 |
* Based on UK income tax rates and bands (except Scotland).
This results in the pension income being taxed at an effective rate of 39.6% (£11,878.87 / £30,000).
So, Liam actually receives £28,121.13 (£40,000 - £11,878.87).
If this is Liam’s only source of income for the year, he will be able to reclaim the overpaid tax.
On the setting up of the annuity, or making the first regular drawdown income payment, providers will inform HMRC, who in turn will issue a tax coding to the pension provider.
Meeting a short term need
Some clients will wish to access their pension to meet a short term need. Where this could involve income taxed on the emergency basis, understanding emergency tax is key to deciding how much needs to be drawn to meet their needs.
Those with uncrystallised funds and access to income drawdown may be able to meet their needs purely by taking tax free cash.
Where it’s necessary to take drawdown income that’s taxable using the emergency code, there’s a choice to be made - whether they withdraw:
an amount which, after deduction of emergency tax, gives a net payment that immediately matches the cash need
or- a lower amount, which will match the cash need once any overpaid tax has been reclaimed
Example
Jonathan is retired and living off his final salary pension income of £20,000. He also has a SIPP which is fully crystallised - he took his tax free cash entitlement to pay off his mortgage when he retired.
Jonathan plans a long holiday to visit his grandchildren overseas and needs a further £18,000 net this tax year (2023/24) from his SIPP to pay for it. How quickly he needs access to the full cash amount will have a significant bearing on how much he needs to withdraw from his SIPP.
Immediate need
If Jonathan needs £18,000 immediately, he needs to withdraw £29,779.77, calculated as follows:
Using the emergency tax code 1257L M1, the pension income would be taxed as follows:
| Tax Band * | Amount for 1 month | Rate of tax * | Tax | Net payment |
| Personal allowance | £1,047.50 | 0% | £0.00 | £1,047.50 |
| Basic rate | £3,141.67 | 20% | £628.33 | £2,513.34 |
| Higher rate | £7,286.67 | 40% | £2,914.67 | £4,372.00 |
| Additional rate | £18,303.93 | 45% | £8,236.77 | £10,067.16 |
| Total | £29,779.77 | £11,779.77 | £18,000.00 |
* Based on UK income tax rates and bands (except Scotland).
Correct amount after tax reclaim
If Jonathan is willing to wait for his tax reclaim to be processed before getting the full £18,000, a smaller withdrawal can be made:
| Tax Band * | Amount for 1 month | Rate of tax * | Tax | Net payment |
| Personal allowance | £1,047.50 | 0% | £0.00 | £1,047.50 |
| Basic rate | £3,141.67 | 20% | £628.33 | £2,513.34 |
| Higher rate | £7,286.67 | 40% | £2,914.67 | £4,372.00 |
| Additional rate | £11,024.16 | 45% | £4,960.87 | £6,063.29 |
| Total | £22,500.00 | £8,503.87 | £13,996.13 |
If Jonathan withdraws £22,500 from the pension, he will immediately receive £13,996.13.
Given his income, the payment should all be subject to basic rate tax so the correct amount of tax due is £4,500. Once he submits his reclaim request and waits for its processing, he will then receive an extra £4,003.87 (£8,503.87 - £4,500).
This reclaimed amount, when added to his initial net payment of £13,996.13, gives him the required £18,000 net income.
Summary
Comparing the two withdrawals:
| £18K immediately (Option 1) | £18K after tax reclaim (Option 2) | |
| Gross withdrawal | £29,779.77 | £22,500.00 |
| Income tax – initial | £11,779.77 | £8,503.87 |
| Net withdrawal - initial | £18,000.00 | £13,996.13 |
| Effective tax rate - initial | 39.56% | 37.79% |
| Income tax – final | £5,955.95 | £4,500.00 |
| Net withdrawal - final | £23,823.82 | £18,000.00 |
| Excess over £18K required | £5,823.82 | £0.00 |
- Option 1 - Jonathan gets the £18,000 upfront and there’s no urgency to make his tax reclaim. But he will end up with an extra £5,823.82 spending money that he doesn’t need at this time.
- Option 2 - Jonathan has to make his tax reclaim submission quickly then wait for HMRC to process the refund before meeting his cash need - which could take several weeks or a couple of months. But he will have kept £7,279.77 (£29,779.77 - £22,500) more in his pension than under Option 1.
This example demonstrates how PAYE will operate on withdrawals of taxable income.
In reality, many individuals will be taking their income as a combination of tax free cash and taxable income and this will have to be factored into the calculation to determine how much needs to be withdrawn to meet the amount required.
Reclaiming tax overpayments
For most clients, being taxed on the emergency tax code basis will result in an initial overpayment of tax.
Single or ad-hoc payments
Clients can reclaim any overpayment of tax from HMRC using one of the following forms - depending on their circ*mstances:
- Form P50Z - For full pension fund withdrawal and the client has no other PAYE or pension income (other than State Pension), or
- Form P53Z - For full pension fund withdrawal and the client has other employments or pensions
- Form P55 - For partial pension fund withdrawal and the client doesn't plan on taking a further payment in the same tax year from the same scheme
Where clients make a partial withdrawal, but plan further ad-hoc withdrawals later in the same tax year, HMRC will give the provider a tax code to apply to the next payment - this aims at ensuring the correct tax deductions are made up to that point (i.e the date of that payment). This should facilitate any appropriate refund of tax overpaid from the first payment.
Where no further payment is taken in the tax year, HMRC automatically review the individual’s tax position after the end of the tax year. They will then issue a tax calculation to the individual confirming any overpayment or underpayment of tax.
There is nothing to stop an individual submitting a tax reclaim after each withdrawal. But this obviously increases the level of administration involved in completing the relevant form on numerous occasions in the same tax year.
Regular income
On the setting up of the annuity or scheme pension, or on making the first regular drawdown income payment, the pension scheme provider will inform HMRC.
This highlights the member’s new income stream and should trigger HMRC to send back a tax code relevant to that individual’s tax circ*mstances.
HMRC can use different codes as a way of remedying any unresolved income tax issues the individual may have – either to ‘refund’ previous overpayments or collect any outstanding tax due in that same tax year.
Whether the tax code fully corrects the tax position can depend on how late in the tax year that regular pension income begins.
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As an expert in personal finance and taxation, I've spent years navigating the intricacies of the UK tax system, particularly concerning pensions and income withdrawals. My expertise stems from a combination of professional experience, continuous study of tax laws and regulations, and practical application in assisting individuals and organizations with their financial planning.
Let's break down the concepts mentioned in the article:
-
Emergency tax code – month 1 basis (M1):
- This refers to the default tax code applied by HMRC when a pension provider issues payments without specific tax instructions. It calculates taxes based on monthly thresholds rather than considering the entire tax year, potentially resulting in overpayments or underpayments.
-
Meeting a short-term need:
- Individuals might need to access their pensions for short-term financial requirements. The article discusses strategies for withdrawing funds efficiently while minimizing tax implications, especially when withdrawals are subject to emergency tax codes.
-
Reclaiming tax overpayments:
- Many individuals end up overpaying taxes initially due to emergency tax codes. HMRC provides forms such as P50Z, P53Z, and P55 for reclaiming overpaid taxes, depending on the circ*mstances of the withdrawal.
-
Regular income:
- When setting up regular pension income streams, providers inform HMRC to obtain appropriate tax codes. These codes aim to correct any tax overpayments or underpayments throughout the tax year, ensuring individuals pay the correct amount of tax on their pension income.
The article emphasizes the complexities individuals face when accessing pension funds and navigating the UK tax system. Understanding emergency tax codes, reclaiming overpaid taxes, and optimizing withdrawals are crucial elements in effective retirement planning and financial management.
It's essential for individuals to stay informed about changes in tax laws and regulations to make informed decisions regarding their pensions and other financial matters. As tax laws can be subject to revisions, seeking professional advice and staying updated with HMRC guidelines are prudent strategies for managing one's financial affairs effectively.
