Tax doesn’t have to be taxing says HMRC. Well they clearly weren’t considering tax on pensions when they made that statement!
I thought things were confusing enough when I sat down with my mother some years ago to discuss her retirement plans. Back then I only had to consider what to do with a defined benefit pot, some AVCs and a state pension and trying to figure out how much tax she would pay was not simple. Luckily of course, most pensions are taxed at source and so we can just sit back, relax and just rely on the administrators to get this right for us. Or so you would think.
A typical pension today is paid through PAYE to ensure pensioners don’t have to manage their tax affairs and complete tax returns. Most administrators use an off the shelf 3rd party payroll or administration system to manage tax records and tax outgoing payments. In the past, this generally worked quite well.
Then came pension freedoms and flexi-access drawdown, so we’re no longer talking about one or two pensions paying out on a monthly basis. If my mother was to be planning retirement now, we could be talking about many individual pension pots, multiple drawdown arrangements and payment on a regular or irregular basis as well as one off payments and UFPLS.
The average man (or woman) on the street has little chance of working this all out on their own or trying to figure out their tax position. That’s okay though, because the administrator will sort it all out for us. Well unfortunately this often doesn’t appear to be the case.
Payroll systems in use originally intended for employee payroll, have not been updated to understand these new pension freedoms. In fact in most cases they do not have the concept of making pension payments at all. Most still only support weekly or monthly payroll and cannot cope with irregular or ad-hoc payments. They don’t cater well for multiple accounts or drawdown arrangements making payments to the same pensioner and don’t have the means to apply correct tax codes. Similarly, legacy systems, particularly in the annuity sector are hard to update and often can’t keep up with the recent changes to regulations.
Add to all this the fact that HMRC guidance is confusing at best and often seemingly contradictory and we’re left with a bit of a mess.
The result of this is that payments can often be under or over taxed and regularly misreported to HMRC. This leaves pensioners putting their trust in their administrator, but ultimately could end up either exposed to tax bills they’re not expecting, or not receiving the benefits they’re entitled to and having to reclaim overpaid tax.
As an example, if my mother today decided to take some of her pension into drawdown and take a quarterly payment, a traditional payroll system would likely manage her tax record on a monthly payment basis. If she was paid in the first month of each quarter in the tax year, she would miss out on 2 months of tax relief on each payment she received. On a quarterly payment of £3,000 this would see her lose tax relief on roughly £2,000. As a higher rate tax payer this could mean she was underpaid by around £800. You’d get the missed allowance from Q1 back in Q2, but lose it again from Q2 and so on. Unlike a normal monthly PAYE payment, it wouldn’t work itself out so she’d end the year nearly £800 down in overpaid tax and have to reclaim it or wait for the following year’s tax code to get it back. But then of course she’d still be overtaxed next year too.
Worryingly, some administrators don’t seem to be aware of the problems or even some of the regulation itself. Even worse, HMRC know it’s going on, but often aren’t doing anything about it!