Health warning: Taxation will be different to each and every person reading this so it is important you get personalised advice!
Firstly, there are 2 types of payment from a pension fund, which are:
- Tax free lump sum / Pension commencement lump sum:
Final Salary pension scheme – provided by a calculation which the scheme itself completes. We call this calculation “commutation”.
A personal or individual pension – 25% of the fund value at the point of “crystallisation”. Be aware however, some older schemes may have “protected tax-free cash” which will allow more than the standard 25% to be drawn tax-free. The “enhanced” or “protected” tax free cash could be anything above 25%, including 100%!
As the name suggests, these payments of tax-free cash (within the Lifetime Allowance) are paid tax-free.
2. Taxable income / scheme income / annuity income / drawdown income:
All UK pension schemes, whether occupational (from group / workplace arrangements) or personal (from individual arrangements) will pay the taxable pension income via a PAYE system. Basically, eventually they will try to deduct the correct amount of tax before payment is made to the member (you) and pay this across to HMRC on your behalf.
HMRC will provide the payroll operator with a “tax code” based on the members individual circumstances. (all in a very similar way to how an employer would pay your wages)
When could I pay more tax? (Emergency tax codes)
When you receive your first income payment from your pension provider, they will then notify HMRC that you should now be included in their payroll records. HMRC will then send the correct tax code for the payroll operator to use. As this can take a little time (usually 2 or 3 months), pension income providers will use what is known as “Emergency month 1 basis” until this is received.
This means, the pension company will test each individual payment against one-twelth (1/12) of the personal allowance. Where you have had any other taxable income payments in the tax year, for example another pension or salary for example – this will result in overpayment of tax. When the “tax coding” catches up, this should subsequently be corrected.
Other points to consider
- Scotland and Wales now have additional rates of tax payable but during the time where no tax code has been received, the English rates will be used initially.
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