Cash and Income payments

It has always been possible to take 25% of your pension pot as a tax-free lump sum but now everybody can take the remaining 75% of their pension pot as a cash sum as well, but it will be taxed at your marginal rate.

There are two ways in which you can take cash from your pension:

• Ask your pension provider to pay your pension pot as a cash lump sum
• Ask your pension provider to pay part of your pension pot as a cash sum - Uncrystallised Funds Pension Lump Sum (UFPLS)

Uncrystallised Funds Pension Lump Sum (UFPLS)

UFPLS is a payment option which allows your insurance company to pay you a chunk of your pension pot as a cash sum when you reach retirement age (normally any time after age 55). It is taxed in the normal way; 25% tax free and 75% taxed at your marginal rate.

You can take a series of UFPLS payments spread over several tax years in order to reduce your tax bill.

Money Purchase Annual Allowance (MPAA)

Taking a UFPLS will trigger the Money Purchase Annual Allowance (MPAA). This can be complex, but if you take more than 25% of your pension pot (e.g. UFPLS) or take income from a flexi-access drawdown plan, and you are still paying into a money purchase pension, the MPAA will apply.

You will be subject to a tax charge if your total money purchase pension contributions exceeds £10,000 per tax year.

See below for more on Money Purchase Annual Allowance

Top Tip - The most important thing to understand about cash sums taken over your tax-free amount is that they will be taxed as income at your marginal rate. Therefore, if you take a large cash sum you could end up paying higher rate tax. Remember that your provider will deduct tax at source, which means that you will only receive the after-tax amount.

Tax on lump sum payments - 2024/2025 tax year

If you take all or some of your pension pot as a lump sum you will be paid as follows:

• 25% of your pension pot will be paid tax-free.
• The remaining 75% of your pension pot will be taxed at your marginal rate.

For example, if you are a basic rate tax payer:

*Higher rate taxpayers will pay a higher rate of tax

However, if you have already taken the 25% tax free sum and you take another cash lump sum you will be taxed at your marginal rate.

Most people expect this to be a simple deduction of 20% for basic rate payers and 40% for higher rate tax payers. But this is not always the case because the way the PAYE system works and your pension provider may deduct emergency tax.

Pension providers must tax ad-hoc cash or your first regular income payments on the month 1 basis (emergency tax) if they don’t have an up-to-date tax code for you.

Emergency tax on pension lump sums

Pensions, including lump sums, are paid through the ‘Pay As You Earn’ (PAYE) system. This means any tax payable is deducted before you receive your payment. Under PAYE, any payments you receive will be treated as though they will continue to be paid each month like a regular salary or income.

When you take your first pension payment, an emergency tax rate will be applied unless your pension provider has a current tax code for you.

Emergency tax is a way of ensuring enough tax is being collected because HMRC assume you will be paid this amount every month (even though you know it is only likely to be a one-off payment).

The emergency tax calculation is complicated but it means you will pay more tax on a one-off payment than you should pay.

If you are interested in the detail, your pension provider will apply 1/12th of the personal allowance (£12,570 in 2024/25) to the payment, and will assess the remaining payment against 1/12th of each of the income tax bands currently in force.

The tax code used for emergency tax in the 2024/25 tax year is 1250L/M1. This code assumes you can receive £12,570 a year without deduction of tax, broken down over the year into 12 equal chunks.

The example below assumes the 25% tax-free cash sum had already been taken, the tax payable on a £10,000 payment using emergency tax will be as follows:

But the good news is you can reclaim any overpayment of tax.

Claiming back emergency tax on a pension

Any overpaid tax will normally be recovered through an adjustment to your code for future income payments.

HMRC will issue a revised tax code for the provider to apply to future payments.

However, if you will not be taking any more cash or income later in the year against which the additional tax can be offset you can apply for a tax reclaim.

You have two options – you can wait until the end of the tax year and a tax refund will be created as a result of the information submitted in your tax return or you can reclaim the overpaid tax direct from HMRC immediately by using the appropriate claim form.

If you decide to reclaim any overpaid tax you can ask HMRC for one of the following forms;

• P50Z form – If you have withdrawn your entire pension and have no other income.
• P53Z form – If you have withdrawn your entire pension and have other sources of income.
• P55 form – If you have not withdrawn your entire pension & won’t withdraw further pension income in the current tax year.

For further information you can visit www.gov.uk/claim-tax-refund