Pensions  

How overpayments in pension tax occur

  • Describe the taxing system for lump sum and drawdown payments on pensions
  • Identify why overpayments are built into the system
  • Explain how to remedy this for a client, if affected
CPD
Approx.30min
  1. HMRC will automatically correct the tax position at the end of the tax year as part of the normal PAYE process by sending a P800 tax calculation and refunding the overpayment. If too much tax has been paid and a P800 tax calculation has not been received, then the member can complete a self-assessment or contact HMRC direct for a reclaim.
  2. An in-year claim can be made using the appropriate form.

Provided the form is correctly completed, HMRC should repay the tax within 30 days. 

Planning points 

If members are taking a one-off pension payment it is important they are aware of how the tax works to avoid nasty surprises, especially if they are withdrawing funds for a specific purpose that is time sensitive. 

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It is also likely that the first instalment of regular payments may be overtaxed (unless monthly income starts in April). This is less of an issue as it should get corrected throughout the year, but the first payment may still be less than the member would be expecting. 

The future

The issue of over taxation has been raised with HMRC on many occasions, both by the industry and the Office of Tax Simplification. 

One argument HMRC has used to keep over taxing is that it is better for those on low income to be overtaxed initially, so they do not have a tax bill later once the money is spent.

However, where the member has told their scheme administrator that they are only taking one payment in the tax year it seems very inefficient for everyone involved to deduct tax at a rate that will never be correct. 

The current system is something of a one-size-fits-all approach, which in fact seems to be pretty inconvenient for almost everyone. 

What we would like to see implemented instead is a more pragmatic approach.

This would mean that when the member has made it clear they only intend to take a one-off payment in the tax year, scheme administrators are then allowed to use a month 12 basis, effectively giving the whole personal allowance for the payment, and then full bands after that.

Yes, there is a risk that if the member changed their mind, or their circumstances changed, and they needed to take a subsequent payment in the year then they would face higher tax charges relating to these, but warnings could be given when the first payment was made, and these cases would be the exception.

Certainly, we would not expect to see cases in the tens of thousands as we do under the current setup, which leads so many people to overpay tax.

It would surely it be favourable for those few to be taxed incorrectly, rather than the thousands we have now. For now, however, we seem to be stuck with the current system.

So it is important for advisers to be familiar with the way tax is applied on pension income withdrawals, so that clients can be fully informed and are able to reclaim overpaid tax where necessary. 

Lisa Webster is senior technical consultant at AJ Bell

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. HMRC has repaid £1bn in overpayments of pension tax, true or false?

  2. Which tax are uncrystallised funds pension lump sums and flexi-access drawdown payments subject to?

  3. What does taxing on a 'month one' basis mean?

  4. Being charged tax on a month one basis rather than month 12 is the reason for overtaxation, true or false?

  5. HMRC will automatically correct the tax position at the end of the tax year as part of the normal PAYE process, true or false?

  6. Why does HMRC say it will keep the system?

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You should now know…

  • Describe the taxing system for lump sum and drawdown payments on pensions
  • Identify why overpayments are built into the system
  • Explain how to remedy this for a client, if affected

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