Over the past three and a half years, many of those accessing their pension money for the first time have had a nasty surprise - a hefty chunk of their retirement savings taken by ‘emergency tax’.

This is money HM Revenue & Customs may very well have paid back - HMRC has repaid more than £370m - but it is still likely to have been a nuisance for retirees to deal with, or worse if the money was needed there and then to meet spending commitments.

The issue has been a bugbear of savers and the pension industry but the Government’s Office of Tax Simplification recently confirmed it would not alter tax rules to help avoid cases of emergency tax on pensions.

Here’s what you need to know to find out if you’ll be hit, and what you can do to avoid it.

Why is pension money taxed at the ‘emergency’ rate?

Like an employer paying your wages, pension schemes paying out pension money are expected to apply a tax code to you.

The problem is, they are unlikely to have one. In those circumstances, pension schemes apply a ‘Month 1’ tax code. This can be spotted if your tax code ends ‘M1’. 

The effect of this is that the Personal Allowance - the amount of income we can all receive without paying tax - is dramatically reduced,  to just one twelfth of its normal level. What’s more, the amounts you can then receive that fall into the Basic Rate and Higher rate bands also fall to a twelfth, meaning that anything over this is taxed at the highest 45% Additional Tax rate leading to a much higher tax bill overall.

These rates apply in England Wales and Northern Ireland, Scotland has its own rates.

Lump sum or income? 

Emergency tax is a problem when it is applied to regular income, but the system should correct the overpayment without further action within a few weeks once a correct code is generated and passed to your pension scheme.  

It can be more of a problem on lump sum payments where there are not regular ongoing payments. The tax bill jumps far higher and it takes longer to put right.

How much higher? Take this example: if you were to take a £14,000 lump sum from a pension, but had no other income in that year, you should pay no tax. That’s because 25% is tax-free under pension tax rules, while the remaining £10,500 would fall within the Personal Allowance where no tax is due.

Apply emergency tax, however, and a £3,230 tax bill is generated - or more than 23% of the original lump sum.

Watch out if you take lump sums at the start of the year

It can be possible to pay too much tax on a lump sum even when emergency tax isn’t applied. 

If a lump sum is taken for the first time near the start of the tax year, HMRC will apply a reduced Personal Allowance that will raise your tax bill in a way similar to emergency tax. 

Putting things right

If you have made an overpayment, due to emergency tax or for any other reason, the Government created a page online to help you claim a tax refund.

You will have to submit a form to claim your money, and the online tool will guide you to the right one.  If HMRC needs more information, it should contact you, otherwise valid claims will be paid within 30 days. 

It may also be possible to claim the tax back through the self-assessment process.

Can you avoid emergency tax?

One way to help avoid emergency tax falling on your pension lump sum is to make a much smaller withdrawal - technically known as an ‘uncrystallised funds pension lump sum’ (some more information is available on that here)  - of say £1,000 so that emergency tax is applied to that. 

Once a correct tax code has been generated and passed to your pension scheme, you should be able to proceed with a larger payment and be taxed correctly. 

The Government offers a free and impartial guidance service to help you understand your options at retirement. This is available via the web, telephone or face-to-face through government approved organisations, such as The Pensions Advisory Service and the Citizens Advice Bureau. You can find out more by going to pensionwise.gov.uk or by calling Pension Wise on 0800 138 3944.

Fidelity has produced a pension tax relief guide here, and you can also use our retirement calculators to find out if you’re on track to meet your retirement goals.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.