Key points

You can currently access your pension pot from age 55, at which point you can take up to 25% of your pension fund value as tax-free cash, either as a lump sum or regular income. The remainder of the funds left in your pension pot are then taxable as income as you draw them. Either by way of buying an annuity, or by taking cash directly from your pension fund known as Flexi access drawdown (FAD).

How is pension income taxed?

Pension income either through a final salary pension, lifetime annuity pension or FAD is taxed as ‘Earned Income’ for any of the pot not qualifying as tax free cash. This means that the payer of the income must operate a Pay As You Earn (PAYE) scheme. They will be supplied your tax code by HMRC and deduct any income tax due at source.

In addition, you also have the option to take an Uncrystallised Funds Pension Lump Sum (UFPLS). Although this provides the full pension pot as a single lump sum there are tax implications.

The income is initially set up with an ‘Emergency tax code’ (month 1) with an assumption that you will take the same amount each month going forward. An ‘Emergency Month 1’ tax code means any income is tested against 1/12th of the personal allowance, 1/12th of the basic rate tax band and so on.

In practice this means that the first payment is allocated 1/12 th of the 0% tax band. 1/12 th of the 20% tax band etc. For the 21/22 tax year this would be;
1/12 th @ 0% = £1,049
1/12 th @20% = £3,142
1/12 th @40% = £9,359

The first £1,049 of each monthly payment is paid tax-free. The taxable income is rounded down to the nearest pound then, the next £3,142 is taxed at 20% and so on until the tax code is received.

The tax code provided by HMRC depends on each individual. That tax code will be applied either on a 'Month 1' basis or a 'Cumulative' basis. If cumulative is used the situation becomes more complex.

If you were taking a lump sum rather than a regular income then you would most probably pay too much tax and need to reclaim this back from HMRC. Monthly income usually resolves the tax situation over a few months.

Taxation of an Uncrystallised Funds Pension Lump Sum

If you have a fund of £100,000 and want to encash the full amount you would get £25,000 tax-free, with £75,000 taxed at your marginal rate. For example, if this is the only income you have in the tax year you would fall into higher rate tax and would only receive £82,568.

£25,000 tax-free + £75,000 taxed.

Tax (£12,570 x 0%) + (£37,700 x 20%) + (£24,730 x 40%) = £17,432 tax liability.
£75,000 – £17,432 = £57,568
Total to be paid out – £57,568 + £25,000 = £82,568

However, it is highly likely that emergency tax will be applied to the payments from UFPLS which could mean that the tax deducted would be £32,023 rather than the £17,432 shown above resulting in a net payment of £67,977 and not £82,568!

If you have overpaid tax they may be able to ask HMRC for this to be repaid in the same tax year. Otherwise HMRC will calculate whether they have over or underpaid tax in the following year.

If you need help or advice with pension income please contact me, Claire Blake on M: 07767 308783 or E: claire@bdfinancial.co.uk.