The Bank of Mum and Dad is doing brisk business. One survey estimates it will lend £6.3 billion this year – putting it 11th on the list of UK mortgage firms. Except this one does not usually ask for the money back!
As Christmas approaches, many mums and dads may be considering that best-ever present for their children – helping them buy their first home. Or perhaps they’d love to treat each other to a special, extravagant gift this year – say, a garden office or a cruise. But how to fund this generosity? One way is to use part of a pension pot.
The taxman takes a cut
Since 2015, anyone with a pension fund who is aged 55 or more can take money out of it or cash it in completely. In the 12 months to September this year, more than a million people took out £9 billion. If you are thinking of using a pension pot to fund a super Christmas gift, beware. The taxman will want a present too. And he nearly always takes an extra box of cash that doesn’t even have his name on it.
When you take money out of your pension pot, the first 25% of the fund is tax free (with some older pension schemes it can be more). The rest is treated as income and taxed in the year you withdraw it. If you take out a substantial amount which pushes your total annual income to more than £50,000, some of it will be taxed at 40%. If it takes your income over £150,000, some will be taxed at 45%.
But that is not enough for HMRC. If you take out, say, £50,000 from your pension, HMRC will assume that the taxable part – £37,500 – is not a one-off but a new source of income. It works out your tax as if you will be paid that much every month for the rest of the tax year.
Here is an example of how it works. Your income is £26,000. Your pension pot is £50,000 and you took it all out in October. First, deduct the 25% that is tax free. That is £12,500 tax free, leaving £37,500 to be taxed. Adding that to your normal income gives a total of £63,500, bringing it above the threshold for higher-rate tax, so some of the £37,500 will be taxed at the basic rate of 20% and the rest at 40%. The actual tax on it should be £10,200, about 20% of your total £50,000 pot.
Then comes the complicated bit. Instead of taking £10,200 tax off your fund, HMRC will also tax that assumed extra income, as if you would get £37,500 extra taxable income every month for the rest of the tax year. The later in the tax year you withdraw the money, the less this effect will be. If you took it out in October, £15,155 will be deducted in income tax, which is £4,955 more than the tax of £10,200 you actually owe.
So out of your £50,000 you will get £12,500 tax free and £22,345 after tax on the rest, which leaves you £34,845. But you are also owed back another £4,955 excess tax, which when you get it will give you a total of £39,800 after tax of your £50,000 pension fund. Your own results will of course be different, depending on your other income, when you cash in your pension, and how much you take out of it.
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Reclaim the extra tax
The higher – wrong – amount of tax is automatically calculated and deducted by the firm that holds your pension before it pays the money over to you. It has no choice. You will of course get it back. HMRC will do the sums after the end of the tax year and refund you.
Alternatively, instead of waiting for months, you can reclaim the extra tax at once. If you have taken all the money out of your pot, you will usually need a form called P53Z. Other forms are P50Z (if you do not work or claim benefits) or P55 (if you take only part of your pot). You can claim online and if you are not registered for online tax services, you can register as part of the claim. Otherwise you can print off the form, fill it in and post it to HMRC. It says it will refund the money within 30 days. In the three months from July to September this year, it refunded 17,385 people a total of £55 million – that’s more than £3,100 each.
Is taking money from your pension pot sensible?
Although it is great to have a lot of money to spend on a special gift for people you love, you must consider whether this is a sensible use of your pension money. It is supposed to provide a regular income for you and keep you, if not in luxury then certainly out of poverty, in your old age.
But the temptation is there. After all, no one knows how long they will live. So it could seem worthwhile to use some of it now to help that son or daughter get their first home. Or you may be tempted to improve your own home or perhaps buy that once-in-a-lifetime holiday – a safari or even a round-the-world trip.
If you do decide to use some of your pension pot, whether it is for something naughty or nice, make sure HMRC does not keep the extra present it grabbed for too long. After all, it has not been that good this year, has it?
Work out the tax on cashing in your pension pot at Fidelity; search ‘pension tax calculator’. Its figures and those in this article are indicative and rounded and may not reflect your own pension pot.
Claim the tax back now at gov.uk; search ‘P53Z’ if you took all of your pot, or ‘P55’ if you withdrew part of your pot.
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