Be wise to pension tax

If you’re taking cash out of your pension, the tax man will want a slice

Positive  pension Happiness money saving for Retirement financial

The move to take money out of our pensions shows no sign of decline.

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In the past 12 months, people aged 55 or over cashed in more than £8 billion from their pension pots.

Since pension freedom began in April 2015, we have taken out more than £25 billion.

Cashing in a pension may or may not be a good idea for an individual. But it is bringing in a lot of money for the Chancellor.

The first 25% of a pension fund is usually tax-free, but the rest is taxable in the year you take it out. That can mean a higher rate of tax is due on the money.

However, the Revenue goes even further. If you take out, say, £50,000, HMRC will assume that the taxable part – £37,500 – is a new source of income and that you will be paid that much every month for the rest of the tax year. So if you take it out this month, June, HMRC will assume your income has magically increased by £37,500 a year, pushing you into the top 45% tax bracket.

For example, your other income is £26,000 and you take out your pension pot of £50,000.

Deduct the 25% tax free, which is £12,500, and you’re left with £37,500 to be taxed. Adding it to your income gives £63,500.

The actual tax on that pension should be £10,200, about 20% of your total pot.

However, HMRC will take far more than that because it will assume that extra taxable income will happen every month for the rest of the tax year.

At the moment, for example, it will deduct £15,155 in income tax, which is £4,955 more than the net tax of £10,200 you actually owe.

The exact amounts will vary, depending on when in the tax year you cash in your pension. You can either reclaim that excess tax immediately, or wait for HMRC to – hopefully – do the correct sums during the next tax  year.

I would claim it now. Work out the tax on cashing in your pension pot at fidelity.co.uk where you search “pension tax calculator”.

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Claim the tax back now at gov.uk and search “P53” if you took all of your pot or “P55” if you took part of your pot.