Pension income is taxable, just like a salary. Our income tax system works by applying different rates of tax to certain bands of income. Income under £12,500 is not taxed; the next slice of £37,500 taxed at 20 per cent; after that £112,500 at 40 per cent and; anything above that is taxed at 45 per cent.
The PAYE system works by the payer deducting tax and paying this to HMRC on the taxpayer’s behalf. The payer is provided with a 'coding notice' by HMRC, and this determines how much tax is deducted from each payment. The system works well where payments are made regularly, such as monthly salary payments. Over the course of the year, the total tax deducted should equate to the actual tax liability on that income.
However, the system fails where there is a one-off payment, such as when a pensioner flexibly accesses their pension pot for the first time. This is because the pension provider will not have received a coding notice and consequently, does not know how much tax to deduct.
In these circumstances, it uses the 'Month 1' basis, which has come to be known as the 'emergency tax rate'. The month 1 basis assumes you will receive a similar amount of income each month, and therefore calculates the tax due by reference to one twelfth of the personal allowance, and one twelfth of the 20 per cent band and so on.
Anecdotally, the nickname leaves taxpayers believing that they have paid tax at a higher rate i.e. an 'emergency rate' rather than the normal rates, because the tax deducted is higher than the actual liability on that one-off payment, assuming there is no other income.
If you are only dipping in to your pension pot as a one off, it is very possible that the pension provider will therefore deduct too much tax from the payment, leaving you short. This only goes to reinforce the position in taxpayers’ minds that they have paid tax at the higher (non-existent) emergency rate.
It is also a common misconception that where tax has been over-deducted in this way, the taxpayer must wait for the end of the tax year to reclaim the overpaid amount. HMRC has anticipated the problem, and taxpayers can reclaim the estimated tax over-deducted during the tax year by submitting forms which are available on its website.
Taxpayers should also ensure that they understand whether accessing their pension will mean that they trigger the money purchase annual allowance – meaning that they will be restricted on the amount they can contribute in the future which attracts tax relief. This is only important if they’re planning to go back to work after the coronavirus restrictions have been lifted and continue to make pension contributions.