Just because you can doesn't mean you should
In my opinion, this has never been more true than when applied to the new “Pensions Freedoms”. The loosening of legislation surrounding what you can and cannot do with your pension has largely been a good thing. The old system was restrictive and archaic, it needed reform and the new rules have done this both 'Root and Branch'.
This is one of a series of blogs I intend to write about the new pensions reforms over coming weeks and relates to a real enquiry I received a handful of days into the new regime, it relates to taking the whole pension fund as cash and illustrates why you should probably not entertain this as a way of raising cash.
I was approached by a couple (let's call them Mr and Mrs Smith) who needed to raise some money for a deposit so one of their children could clamber onto the property ladder. They are comfortably off, both in their late 50s, and are 40% tax payers (let's assume they are earning £45,000 each). The sum total of their pension assets was £145,000 - £55,000 for Mrs Smith and £90,000 for Mr Smith (the figures have been rounded to make the calculation easier to follow). They wanted to know whether they could take the whole fund as cash (yes) and for some idea of the tax liability.
This is where the plan began to unravel. The 25% pension commencement lump sums freed up £13,750 and £22,500 respectively, leaving taxable funds of £41,250 and £67,500.
Assuming Mr and Mrs Smith went ahead and cashed in their pensions, just how much tax would they pay? Bear in mind, the new freed up pension fund will be deemed to be earned income (remember this – it is important).
When the pension provider receives an instruction to proceed they will not have a tax code for Mr and Mrs Smith so, will be obliged to assess them under the Emergency Tax Month 1 basis (1060L for 2015/16).
So what does this mean?
• First off, their Personal Allowances will be deemed to be £10,600/12 = £833. There will therefore be no tax on the first £883.
• The basic tax band will be £31,785/12 = £2,649 and the tax payable on this portion will be £529.
• The Higher Rate threshold (40% tax) will reduce to £9,852 so tax of £3,940 will be due on that segment.
• The new personal allowance (covering all the tax bands up to and including 40% tax) will be covered by the first £13,384 of the residual fund and the total tax liability will be £4,469. The balance will be subject to Additional Rate tax at 45%.
• To calculate how much tax is to be paid on the balance is simple (residual fund - £13,384) x 45%.
For Mr Smith then. He has a taxable pension fund of £67,500 so the calculation is as follows:
£67,500 - £13,384 = £54,116 x 45% = £24,352. The total tax payable then is £24,352 + £4,469 = £28,821.
The total cheque Mr Smith would stand to receive from his £90,000 pension fund would therefore be £61,179.
HMRC will deduct the tax and leave it to Mr Smith to reclaim it or to be reassessed in the next tax year, meanwhile his normal salary will be taxed at 45%.
For Mrs Smith, the picture is equally bleak:
• Her pension fund of £55,000 will allow her to take £13,750 free of tax.
• The first £13,384 of the residual £41,250 will be taxed at £4,469 and the balance of
£27,866 will be taxed at 45% (£12,539).
• Her total tax bill will be £12,539 + £4,469 = £17,008 and the cheque she stands to receive is £37,992.
The total (tax) cost of the exercise will be an eye watering £45,829 plus the ongoing tax burden of a 45% charge against their normal salaries until new codes etc have been agreed with HMRC.
How do you go about reclaiming overpaid tax?
All is explained in HMRC Newsletter_68 section 6
As you can see, it isn't going to be easy.
If ever there was a case where advice was needed to prevent paying unnecessary tax this was it.