Mind The Tax Trap: How Your Pension Can Be Hit by Emergency Tax (and How to Avoid It)
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Accessing your pension should feel like a reward, a well-earned milestone after years of working and saving. Whether you’re planning a long-awaited holiday, helping family, or simply topping up your income, you expect it to be a smooth process. But many people are caught off guard when their first pension withdrawal comes with a surprisingly large tax bill, thanks to something called emergency tax.
So what’s going on, and more importantly, how can you avoid paying too much?
What is Emergency Tax on Pension Withdrawals?
When you take money from a defined contribution pension for the first time, your provider usually won’t have a current tax code from HMRC. Without it, they’re required to apply a temporary or ‘emergency’ code, typically on a Month 1 basis.
This means your tax allowances are spread evenly across the year, and the system assumes the amount you’ve withdrawn will be repeated every month. So, if you withdraw £10,000 as a one-off, HMRC’s system assumes you’re going to be drawing £120,000 a year, and taxes you accordingly.
This often results in far more tax being deducted than is actually due especially if you’re just taking a one-off lump sum.
Please note, this does not apply to any tax-free withdrawals you make from your pension, typically the 25% tax-free lump sum. It only applies to withdrawals in excess of this entitlement.
A Real-Life Example
Take David, for example. He’s 62 and decides to withdraw £20,000 from his pension to help his daughter with a house deposit. His financial adviser recommends that he withdraw a part tax-free, part taxable payment (also known as an Uncrystallised Fund Pension Lump Sum), he receives £5,000 tax-free (the usual 25% lump sum), leaving £15,000 that should be taxed at his usual rate. But because it’s his first taxable withdrawal, HMRC hasn’t issued a tax code yet so the provider uses the emergency tax method.
David ends up being taxed as if he’s going to take £15,000 every month. The outcome? Far more tax is taken than necessary, and David receives less than he expected often by thousands of pounds.
Why Does This Happen?
It’s not a mistake, it’s simply how the tax system works in the absence of proper coding. Providers must follow HMRC guidance, and the emergency code is intended to prevent underpayments. Unfortunately, it often leads to overpayments, especially on one-off withdrawals.
Can You Avoid It?
In many cases, yes or at least reduce the impact. Here are a few practical ways to do just that:
1. Try the ‘£1 Trick’
Before taking out a large sum, consider making a small withdrawal even just £1. This can trigger HMRC to issue a correct tax code to your provider. Then, when you take the larger amount later, it’s more likely to be taxed correctly.
Timing matters, though, so speak to a financial adviser to make sure it’s done effectively.
2. Take Income Regularly
If you’re planning to draw from your pension more than once, setting up a regular income (e.g. monthly) may lead to the correct tax code being used after the first payment.
3. Reclaim Overpaid Tax
If you’ve already taken a lump sum and been over-taxed, you don’t need to wait until the end of the tax year. You can apply to HMRC for a refund using the appropriate form:
· Use form P55 if you’ve taken part of your pension and don’t plan to take more this tax year
· Use form P53Z if you’ve taken your full pension and have other taxable income
· Use form P50Z if you’ve taken your full pension and have no other income
Refunds are usually processed within a few weeks, however in our experience it is taking HMRC around 6-8 weeks on average.
Planning Ahead Makes All the Difference
This isn’t just a tax technicality, it’s a reminder of how important proper retirement planning is. Knowing how and when to access your pension can make a significant difference to what you receive. It’s not just about market performance or fund charges, the way you draw income can affect your tax bill immediately.
This is an area where seeking financial advice can be especially valuable. A financial adviser will help you structure your withdrawals in the most efficient way, reduce unnecessary tax, support you with any HMRC paperwork and make sure you’ve thought through your income needs.
Final Thoughts
Emergency tax catches out thousands of people each year, not because they’ve done anything wrong, but because the system works in a way that doesn’t always match real life. The good news is, with a bit of planning, it’s often avoidable or easily reclaimable.
If you’re thinking about accessing your pension for the first time, whether it’s for a holiday, helping family or supplementing your income, take a moment to consider the tax treatment. Speak to a financial adviser if you’re unsure.