Have you ever booked a holiday promising luxurious accommodation and top-notch amenities, only to find on arrival that it’s lacking a star or two?
If you’re a football fan, you’ll know the all too familiar tale of the pre-season hype, followed by an underwhelming finish in the table. Taking a taxable lump sum from your pension can lead to similar feelings, as it has been far too common for the amount that reaches your bank account to fall short of what you had anticipated.
Since Pension Freedoms were introduced in 2015, due to the Pay As You Earn (PAYE) system deducting excess Income Tax upfront, over 470,000 claims have been made for refunds totalling £1.37 billion[1]. The good news is that HMRC recently announced that from April 2025, they will begin automatically updating tax codes after the first taxable withdrawal from a pension, effectively removing the “emergency” (or Month 1) tax code sooner[2].
What Difference Will This Change Make?
Before you make a withdrawal from a defined contribution pension, such as a personal pension or SIPP (self invested personal pension) HMRC’s PAYE system is not aware it exists. As you may know, we can normally withdraw 25% of our pension free of tax, but when receiving income from pensions, this is subject to income tax. When you take the first taxable withdrawal, your pension provider will put this through the PAYE system with an “emergency” tax code. HMRC typically then issued an updated tax code within the space of a few months, but as of April 2025, this will happen automatically after the first taxable withdrawal, which will still be taxed on an emergency tax code. But will this change result in the correct tax amount being deducted?
In the tax year that income is received, it falls into the income tax bands, which as of the current tax year (2024/25), are as follows:
- Personal Allowance: Up to £12,570 (0% tax)
- Basic Rate: £12,571 to £50,270 (20% tax)
- Higher Rate: £50,271 to £125,140 (40% tax)
- Additional Rate: Over £125,140 (45% tax)
Bands for England/Wales (differs in Scotland)
If you are struggling to sleep, try reading the UK income tax code. It is notoriously lengthy and complex, with aspects like the high income child benefit charge and losing your personal allowance once you start earning over £100,000. But aiming to keep things simple here, let’s say you earn a salary of £30,000, you would expect to pay basic rate tax of 20% on the next £20,270 of income. If you withdrew say £10,000 as income from your pension, before tax, you would expect to have £2,000 deducted (20%) and receive £8,000 net. Unfortunately, if an “emergency” tax code such as 1257L (M1) were used, you would only receive £7,047.94 after PAYE deductions, meaning you would have overpaid HMRC by £952.06.
The reason is that the “emergency” or month 1 tax basis only offers you 1/12th of each of the tax bands with no acknowledgement of previous income or tax paid. With the standard 1257L tax code on this basis, it effectively results in tax bands as follows:
- Personal Allowance: Up to £1,048 (0% tax)
- Basic Rate: £1,049 to £4,189 (20% tax)
- Higher Rate: £4,190 to £10,428 (40% tax)
- Additional Rate: Over £10,428 (45% tax)
It is easy to see why taking larger withdrawals quickly results in having more tax deducted than you should be due to pay to HMRC.
The Remaining Challenge: Cumulative PAYE System
While this change from the new tax year is a step in the right direction, it does not entirely eliminate the issue of over-taxation. The PAYE system is cumulative, meaning it takes into account your total income for the year. If you make a large pension withdrawal early in the tax year, the system treats you as if you are going to receive that income monthly for the rest of the year to evenly spread out the tax deductions.
For instance, if you withdraw that same £10,000 from your pension on the 6th April, the first day of the new tax year, even with the “emergency” or month 1 element removed, on a 1257L tax code you would still have the same tax deduction resulting in an overpayment. If you then take ad-hoc payments later in the tax year, you should at least get closer to the correct tax deductions. For those taking a regular income, you should see tax refunded to you gradually through those payments throughout the tax year.
The bottom line is that the PAYE system doesn’t deal particularly well with ad-hoc income payments and there isn’t a perfect system to deal with this. HMRC would still rather you overpay and approach them for a refund, than you underpay and force them into chasing you for the shortfall. This will mean many people will still need to reclaim overpaid tax, particularly when taking larger lump sums in the early stages of the tax year.
The Importance of Financial Advice
Given the complexities of the PAYE system and the potential for over-taxation, working with a financial planner can help you plan your withdrawals strategically to minimise the tax implications. Taking an initial smaller payment to trigger removal of an emergency code before taking a larger ad-hoc payment might be a strategy that is more regularly employed in future.
As financial planners, we help our clients understand their tax codes, judge the right strategy on taxable withdrawals and assist with any reclaims. A financial planner can help to set the right expectations for what you will receive in your bank account, avoiding any nasty surprises. Ultimately, we can assist in making the experience of taking money from your pension a lot more straightforward.
Would you like to find out more about Active Chartered Financial Planners or speak to a financial planner? Contact the team on 01642 765957 or email info@activefp.co.uk OR visit the website
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Sources:
Used as a guide to aid understanding: Abrdn Tech Zone – Month 1 PAYE
