How to Avoid Paying Emergency Tax on Pension Withdrawals

Accessing your pension can be a valuable lifeline during challenging financial times, but navigating the process carefully is essential to avoid pitfalls like emergency tax.

This blog breaks down the complexities of emergency tax, its implications for pension withdrawals, and strategies for managing and reclaiming overpaid tax.

Understanding Emergency Tax

Emergency tax is a temporary tax code applied when you first withdraw from a pension. Pension providers often lack detailed information about your income for the tax year and must estimate your tax liability. This assumes that your withdrawal will recur monthly, leading to potentially significant overpayments.

For example, under the 2024–25 tax code 1257M1, the system calculates one-twelfth of your personal allowance (£12,570 annually) and applies it to your withdrawal. Income exceeding this portion is taxed progressively at basic, higher, and additional rates.

The Real Impact of Emergency Tax

Consider Tony, a self-employed individual in England. When Tony withdraws £20,000, £5,000 is tax-free. The remaining £15,000 is taxed under emergency tax rules. Instead of paying the standard 20% basic rate tax on this sum, portions are taxed at 40% and 45%, leaving him with a shortfall.

If Tony withdrew £40,000, the emergency tax might assume he withdraws this amount monthly, resulting in a far higher tax liability. Although reclaimable, the excess tax creates short-term financial strain, particularly if funds are urgently needed.

Steps to Reclaim Overpaid Tax

Overpaid tax due to emergency coding is temporary and reclaimable through HMRC. Depending on your situation, you may need to file one of the following forms:

Form P50Z: For individuals who withdraw their entire pension and have no additional income for the tax year.
Form P53Z: For those withdrawing their full pension but with other income sources.
Form P55: For individuals withdrawing part of their pension with no further withdrawals planned for the year.

Submitting the correct form ensures prompt processing, leading to a refund or an adjusted tax code for future payments. Contacting HMRC directly can expedite corrections and refunds.

Minimising the Impact of Emergency Tax

While emergency tax is often unavoidable for the first withdrawal, strategic planning can reduce its impact:

Smaller, Regular Withdrawals: Regular pension withdrawals allow tax codes to adjust after the first payment, minimising overpayment.

Provide a P45: Supplying a valid P45 for the current tax year can prevent using an emergency tax code.

Plan Withdrawals Strategically: If immediate funds are needed, consider withdrawing slightly more to account for potential deductions while considering long-term tax efficiency.

Broader Implications

Emergency tax is not just an administrative inconvenience; it has broader implications for pension planning.

Early pension access may trigger the Money Purchase Annual Allowance (MPAA), reducing your annual pension contribution cap to £10,000.

Additionally, reclaiming tax takes time.

Conclusion

Understanding and managing emergency tax is crucial for making the most of your pension withdrawals. Proactive planning, awareness of tax rules, and swift action to reclaim overpayments can alleviate financial strain and optimise your pension’s value.

At UnaVida Wealth Management Ltd., we specialise in assisting clients with comprehensive pension planning.