Being able to flexibly access pension savings is proving to be an incredibly valuable benefit in these challenging times. But what is also very challenging for advisers and their clients is that ad-hoc pension withdrawals typically result in an overpayment of tax which needs to be reclaimed.

This is because they are taxed on an emergency basis and is a real source of frustration.  A recent poll by abrdn found that 59% of advisers listed it in the top three things they would like to see reformed. 

Increasing demand for flexible access

The events of the last few years have been unprecedented. The changes brought about by the pandemic, and now rising inflation, energy bills, and a cost of living crisis, have seen the demand for accessing pension savings soar.

In fact, recent figures from HMRC show that 2021/22 was a record year for flexible pension withdrawals, with a total of £10.6 billion of taxable income being flexibly withdrawn, up more than £1 billion on the previous year. And in the first three months of this tax year, £3.6 billion has been taken, a 23% increase on the same quarter last year.

But what are the consequences of flexibly accessing a DC pension pot? And how can your client be certain they are going to be receiving the amounts they need after the application of the emergency tax rules?

Accessing pensions and emergency tax

When a taxable income is taken from a pension, the provider must deduct tax through the application of PAYE, much like an employer. However, the first payment is a problem as the pension provider won’t have a tax coding to apply, so HMRC insists that they apply an emergency tax code on a month 1 basis.

The ‘emergency tax code’ is applied because the pension scheme doesn’t know what income the individual may have already had in the current tax year and what tax code they have. So the emergency code will allow the application of the standard personal allowance (£12,570 for this year) and the normal tax bands.

However, it is the month 1 basis that can produce unexpected results.

The PAYE system was designed so a regular income can have a known amount of tax deducted each month, without large spikes, so the correct amount of tax is paid by the end of the tax year.

But it doesn’t cope well with initial payments and ad hoc amounts.

The first flexibly accessed income payment and any subsequent ad-hoc payments are taxed on a month 1 basis. This means that, regardless of which month of the tax year it’s paid in, it’s treated as if it’s the first month and so the payment only gets 1/12^th of the personal allowance and tax bands.

Dealing with shortfalls

Emergency tax will generally result in too much tax being deducted, which can be a problem if the withdrawal is needed for a specific purpose because the client may be left with a shortfall until the overpaid tax can be reclaimed.

This may mean a larger amount needs to be crystallised in order to get the net result needed in the first place. The downside of this is that more is taken out of the tax privileged pension environment than was needed and when the tax liability for the year is reconciled, they will have had more income than was needed.

If immediate cash flow is less important, then they could crystallise just enough to give them the required net amount after the accurate amount of tax due for the year, but receive a lower net amount after emergency tax and then to apply to HMRC for a tax refund (see our ‘Pensions and emergency tax’ practical guide for the methods of reclaim).

However, there is no guarantee on how quickly any overpaid tax will be refunded.

The other option might be to avoid one-off payments and look at a smaller, regular pension income for the year. Though the first pension payment might be overtaxed, the scheme should receive a tax coding to apply to future payments which would provide a greater certainty of net income levels for the rest of the tax year.

There are some situations where the application of the month one emergency tax code will result in an underpayment of tax. This is typically for higher or additional rate taxpayers who may, for example, see part of their withdrawal amount benefit from a slice of the personal allowance (and basic rate band tax band) which may not otherwise be available to them. The additional tax they are required to pay is likely to be accounted for by adjusting their tax coding.

The effect on future funding

One impact of flexibly accessing a DC pension is the money purchase annual allowance (MPAA). The moment the first income payment from flexi-access drawdown is made, or an UFPLS is taken, the MPPA is triggered, reducing the annual allowance for contributions to DC pensions from £40,000 down to £4,000 a year.

This £4,000 limit is for both personal and employer contributions to DC schemes and the ability to carry forward unused allowances ceases as well.

So if a pension has been accessed while the individual is still working, perhaps to meet a short term need, then there can be dramatic consequences for future funding.

If the member had accessed their benefits at age 55, but had been planning to retire at 65, then for 10 years their allowance for DC schemes will be £36,000 lower, missing out a potential of £360,000 in relievable contributions.

Obviously, the impact of the MPAA will depend on income levels, expected future contributions, and time to retirement. It may be less of an issue for those that were only receiving the minimum contributions under an auto-enrolment scheme, or those that are closer to retirement.

It's also possible to avoid the MPAA if only tax free cash is taken. While a flexi-access drawdown fund would be created at the same time, if no income is taken from it, the MPAA is not triggered. Of course, the more tax free cash taken now, the less available at retirement when there might have been a specific plan for it.

Summary

In times of crisis, a pension pot might be very a tempting solution to a need for increased household income, but the consequences of accessing it must be fully understood.

It can be tricky to get exactly the amount that’s needed, with an increased tax liability up front and potential issues for rebuilding the pension.

Careful management, looking at the potential loss of funding up to retirement, tax free cash only options, or using other savings can avoid a big drop in retirement expectations.