Cashing in some of your pension pot early? Beware the pitfall, cautions Paul Lewis.
More people are taking money out of their pension early. Some are probably worried that if they die after 5 April 2027 with a pension pot they leave to their children, large amounts could be snaffled by the Government in inheritance tax and income tax. But beware. Money taken out of your pot before you die is taxed as income. And HMRC routinely takes too much of it, which you then have to claim back – or wait months for a refund.
Since pension freedoms began ten years ago, more than £83 billion has been taken out of pension funds early by people aged 55 or over. Almost all of them will have been overtaxed. That is because HMRC automatically assumes the amount taken out will be a new monthly income!
Calculate how much more income you could get instantly by using our online annuity calculator.
This strange procedure does not apply to the tax-free part of your fund, which is usually 25% of the total. But it does apply to anything above that. So if you take out £10,000 on top of your tax-free amount, HMRC assumes you will have an extra annual income of £120,000 and boom! – you are paying tax at the highest rate of 45% (48% in Scotland).
The firm keeping your pension fund has to deduct the tax before giving you the balance. You get this extra tax back either by waiting for HMRC to realise its mistake and adjust your tax code back to where it should be, by reducing the tax on your other income. Or you can get it back much more quickly by filling in a form.
There are four different ones, but they all begin with P5. Go to gov.uk and search “tax on pension lump sum”, which will give you all the options. You can do it online if you have a Government Gateway account (or set one up – they are handy for all sorts of things). Alternatively, print the form and send it by post. The average refund is more than £3,000, and the more you take out the more it will be. But remember, unless you spend the money, from 6 April 2027 your pension pot will form part of your estate, so inheritance tax could still be due on it.