When care home manager John was nearing his 60th birthday, he thought about taking his full pension fund as a cash lump sum of £25,000 to treat himself and his wife to a luxury holiday, as well as using some of the cash to pay for improvements around the house.
He was still working, with an income of £40,000 a year, and his pension provider explained that 25% of his £25,000 pension fund would be tax free (£6,250) but based on HM Revenue & Customs (HMRC) regulations they would have to apply an emergency tax rate on the rest.
His pension provider went on to explain that whilst an emergency tax rate would be applied initially, this would not be his final tax year-end position and by taking the £25,000 lump sum in addition to his regular income, his total yearly earnings could go into the higher rate tax bracket. John was advised to contact HMRC to check what his final year-end tax position would be.
John went ahead and cashed-in his £25,000 pension policy and after emergency rate tax was applied he received a cheque for £18,134, so had paid £6,866 in tax.
John contacted HMRC to find out what his year-end tax position would be. When they looked at all of his yearly income of £40,000 plus the £25,000 cash lump sum he had received from his pension policy, they confirmed that John had actually overall underpaid on his yearly tax by £34.
Please see below for a breakdown on John’s final tax year-end position.
John’s year-end tax position not including £25,000 pension fund withdrawal:
Other Income £40,000
Personal allowance £11,000
Tax due: £40,000 - £11,000 = £29,000 @ 20% = £5,800
John’s year-end tax position including £25,000 pension fund withdrawal:
£40,000 income earnings + £18,750 (£25,000 – 25% tax free amount) = £58,750
£58,750 – Personal allowance of £11,000 = £47,750
£32,000 to be taxed @ 20% = £6,400
£15,750 to be taxed @ 40% = £6,300
Total year-end tax due, £6,400 + 6,300 = £12,700
At year-end, John had paid £12,666 in tax (£5,800 from his £40,000 earnings + £6,866 from his initial tax payment from his pension fund).
He was actually due to pay £12,700 in tax due to his yearly earnings (£40,000 + pension fund lump sum). This meant he has underpaid by £34.
John also realised that by taking his entire pension savings as a cash lump sum, this had pushed his total yearly income into the higher rate tax bracket which had meant that £15,750 of his £25,000 pension fund had been taxed at 40%.
How will HMRC claim John’s underpaid tax?
HMRC will automatically assess the tax paid after the end of the tax year and contact him directly to correct any under payment.
This case study is a fictional representation of people’s experiences and is for illustration only. It is based on an individual pension policy. Everyone’s circumstances are different and your personal circumstances, however similar to the case study, need to be taken into account when reviewing your pension. This case study does not constitute tax advice or advice or guidance regarding your pension and you should seek pension guidance before making any decision.
Personal allowance and tax rates used are based upon rates for 2016/2017