Finance experts are warning that pensions taking cash from their pensions under new flexible withdrawal rules could face massive unexpected tax bills.
Pension providers have been told by HM Revenue & Customs (HMRC) that they must deduct tax from withdrawals under an emergency tax code from April 6, 2015 unless pensioners can supply a tax coding notice or P45 showing the rate of tax they should pay.
That could mean pensioners may tax at 40% or even 45% and face a delay of up to a year to reclaim the money.
Under an emergency tax code, pensioners would have to pay income tax based on a monthly personal allowance rather than the annual personal allowance, even if they were not planning to take any more cash from their fund in the tax year.
According to finance experts, 40% income tax would start at withdrawals of £4,700 and the 45% rate on taking more than £17,834 in a single drawdown.
Pension advisers NFU Mutual give two examples using the 2015-16 income tax rates –
Taking £17,834 would mean paying £4,470 tax and receiving £13,375. The first £4,458 would be tax-free as 25% of the lump sum.
The rest would attract another £875 tax-free as the monthly personal allowance and then £529.60 tax at 20%; £3,940 at 40% and the rest at 45%.
The tax would eventually balance out after January following the withdrawal when the self-assessment tax return for the year is submitted and any tax refund with interest would be due.
The warning shows over 55s intending to take a flexible pension withdrawal need to think about timing their drawdowns to help their cash flow.
The best time to take cash from a pension would be during March. This would leave a cash flow gap of 10 months, while taking the money in on or after April 6 would mean waiting up to 22 months for any refund.
Sean McCann, a chartered financial planner with NFU Mutual, said: “The small print in the guidance could leave most over 55s taking these flexible pension withdrawals paying initial tax at 40% or 45% when they are really basic rate taxpayers who should pay at 20%.
“This is not a well-publicised consequence of the government’s new pension freedom measures. Although the new rules bring a lot of positives for the over 55s, there are some unexpected pitfalls as well.”
The government’s flexible pension guidance is published on the HMRC web site