Taxation of pension income

Author Image The Technical Team
8 minutes read
Last updated on 6th Apr 2019

Overview

We outline how pension income is taxed as earned income, using Pay As You Earn (PAYE) and cover some key considerations. Usually the income is initially set up with an ‘emergency tax code’.

Key points

  • Pension income either through lifetime annuity, scheme pension or drawdown is taxed as 'Earned Income'. This means that the payer of the income must operate Pay As You Earn (PAYE). This means that they will pay out the income based on a tax code supplied by HMRC
  • What tax code is returned will depend on each individual's circumstances.
  • The Taxation of Pensions Act 2014 introduced a new type of pension payment: Uncrystallised Funds Pension Lump Sum. Although UFPLS do not generate pension income there are tax implications.
  • The introduction of Scottish and Welsh rates of Income Tax (SRIT/ CRIT) will have an impact on those individual defined as Scottish or Welsh Rate tax payers 

How is pension income taxed?

Pension income either through lifetime annuity, scheme pension or drawdown is taxed as 'Earned Income'.

This means that the payer of the income must operate Pay As You Earn (PAYE). Which means that they will pay out the income based on a tax code supplied by HMRC. The same principles as apply to an employer paying a salary. The introduction of Scottish and Welsh rates of Income Tax (SRIT/ CRIT) will have an impact on those individual defined as Scottish or Welsh rate tax payers. 

Operation of PAYE as it applies to pension income

The undernoted is a broad outline of the operation of PAYE and its application in some common scenarios.

The article relates to UK income taxation and where applicable highlights the difference for other rate taxpayers.

Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension). Similarly, from 6 April 2019 Welsh Taxpayers will pay the Welsh Rate of Income Tax (CRIT (C for Cymru)) on NSND income.  

Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. For more info on SRIT and how this works in practice, please visit our facts page. For more info on CRIT and how this works in practice, please visit our facts page.

The income is initially set up with an 'Emergency tax code', commonly 'Emergency Month 1'. At this point the pension payer requests a tax code from HMRC who will return the tax code to be used for ongoing income.

An 'Emergency Month 1' tax code essentially means any income is tested against 1/12th of the personal allowance, 1/12th of the basic rate tax band and so on.

The table below shows the taxation of income payments where an 'Emergency Month 1' tax code applies whilst awaiting the tax code from HMRC.
 

Tax Band

Tax Rate

UK Annual Tax band amounts

UK Month 1 (annual/12) position on payments

Personal Allowance

0%

£12,500

£1,.043

Basic Rate

20%

£37,500

£3,125

Higher Rate

40%

£112,500

£9,375

Additional Rate

45%

Excess

Excess

All figures relate to the 2019/20 tax year

Note - There is no equivalent for emergency tax using Scottish or Welsh rates of income tax, as at the time of payment a provider will not have a tax code to use. Therefore the UK rates are used.

The first £1,043 of each monthly payment is paid tax-free. The taxable income is rounded down to the nearest pound then, the next £3,125 is taxed at 20% and so on until the tax code is received. This will continue until the tax code is received.

What tax code is returned will depend on each individual's circumstances. For example, if the pension income is the individual's only source of income a numeric tax code would be likely (e.g.1250L). Where there are other sources of income then a numeric code of less than the personal allowance, or an alpha tax code will be received e.g. BR.

In addition, the tax code will be applied either on a 'Month 1' basis or a 'Cumulative' basis. If the tax code is cumulative the situation becomes more complex.

The tables below highlight the different treatments and gives examples of the income flows with 2 months at 'Emergency Month 1' tax code and then with some different tax codes applying subsequently:

 

Tax Treatment of different tax codes

This table sets out the position for UK tax rates.  Information for those subject to Scottish or Welsh rates of income tax (SRIT or CRIT) is in the Government's website.

Tax Code

1250L

1250L Cumulative

BR / D0 / D1 20%/40%/45%

BR / D0 / D1 20%/40%/45%

Basis

Month 1

Cumulative

Month 1

Cumulative

Treatment

Operates like emergency tax code in table above - i.e. using 1/12th of the number in the code as the personal allowance each month

Each month look back to assess: total income paid, total tax paid; total personal allowance used in the tax year to date. Then work out tax on current month's income, taking into account the total of these amounts

Appropriate rate is deducted from each payment

Each month look back to assess: total income paid and total tax paid in the tax year to date. Then work out tax on current month's income, taking into account the total of these amounts.

Impact

- net of tax payments will settle down to a regular monthly amount

- tax on the next payment(s) will balance out the tax that should be paid for the year to date
- net income should then settle down to a fairly stable monthly amount but due to rounding may be out slightly month to month.

- net of tax payments will settle down to a regular monthly amount

- tax on the next payment(s) will balance out the tax that would have been paid if appropriate rate of tax had been paid on all income payments from outset
- net of tax payments will settle down to a regular monthly amount

End of tax year

- may be unpaid tax to settle through self-assessment at the end of the year

- total tax should be correct at end of tax year

- may be unpaid tax to settle through self-assessment at the end of the year

- tax should be correct at end of tax year

 

Income recycling

It is important to understand the principles where considering income recycling to understand the impact on the individual's cash flow.

Income recycling is not necessarily 'bank balance neutral' in the short term.

Income recycling example

Income payments from a pension scheme are taxed at source, at the relevant rate. As such a withdrawal from a pension of £1,000, for a basic rate taxpayer, provides a net payment of £800. As pension contributions are paid net of basic rate tax, if the basic rate taxpayer then makes a subsequent pension contribution of £800, this figure would be "grossed up" at basic rate, resulting in a gross pension contribution of £1,000. Therefore the recycling exercise for the basic rate tax payer is tax neutral without any further action being taken. However, this is not the case for all tax situations.

As can be seen below higher and additional rate tax payers will have to provide extra funding to achieve neutrality.

Uncrystallised Funds Pension Lump Sum

The Taxation of Pensions Act 2014 introduced a new type of pension payment: Uncrystallised Funds Pension Lump Sum. Although UFPLS do not generate pension income it's worthwhile discussing the tax implications. For full details of UFPLS please see our technical centre UFPLS article. However, let's take this opportunity to explore the tax consequences of UFPLS.

If a client (age 60) has a fund of £100,000 and wishes to access the full fund, they'll get £25,000 tax-free, with £75,000 taxed at their marginal rate. For example, if this is the only income they have, they will fall into higher rate tax and should receive £82,500*.

*Tax calculation (using 2019/20 UK rates and allowances)

£25,000 tax-free + £75,000 taxed.

Tax (£12,500 x 0%) + (£37,500 x 20%) + (£25,000 x 40%) = £17,500

£75,000 - £17,500 = £57,500

Total - £57,500 + £25,000 = £82,500

In Scotland the tax calculation would be as follows (using 2019/20 Scottish rates and allowances):

£25,000 tax-free + £75,000 taxed.

Tax (£12,500 x 0%) + (£2,049 x 19%) + (£10,395 x 20%) + (£18,486 x 21%) + (£31,570 x 41%) = £19,100.

£75,000 - £19,294 = £55,706

Total - £55,706 + £25,000 = £80,706

However, there is a possibility that emergency tax will be applied to the payments from UFPLS, for example, if it is the first withdrawal from the pension and the scheme does not possess a tax code for the client.

Using the same example as above, assuming no other income and Emergency Tax code for 2019/20 - 1250L. The client will still receive £25,000 of the UFPLS tax free but the actual tax raised on the balance would be:
 

 

UK Band

UK Tax

PA

£ 12,500/12 = £1,043

Nil

BRT

£ 37,500/12 = £3,125

£625.00

HRT

£ 112,500/12 = £9,375

£3,750.00

ART

£ 61,457

£27,655.65

TOTAL

£ 75,000

£32,030.65

 

Therefore taxpayers will find that tax of £32,030.65 will be deducted using the emergency method, instead of the expected £17,500. So the payment they receive would be £67,969.35 and not £82,500, Scottish Rate taxpayers may have expected £80,706. If this method means the client has overpaid tax they may be able to ask HMRC for this to be repaid in the same tax year. Otherwise HMRC will calculate whether they have over or underpaid tax in the following year.

An UFPLS payment would be a trigger event in respect of the Money Purchase Annual Allowance (MPAA), which may in turn further limit Defined Contribution pension contributions before a tax charge is applied. Please see our Money Purchase Annual Allowance article for full details.

© Prudential 2019