Changes to the way HM Revenue and Customs taxes short service lump sum refunds is anything but pensions simplification, says Aegon Scottish Equitable.
In its latest pensions newsletter, HMRC addresses the way tax is calculated on lump sum refunds given by pension schemes if a person has been a member for two years or less.
Rachel Vahey, head of pensions development at Aegon Scottish Equitable, says the original rules which were quite simple and straightforward have now been changed to something much more complicated.
Originally when a pension scheme paid a refund to a member who had been with the scheme less than two years, the sum was taxed at 20% to take into account the previous tax relief on the contributions.
However it seems HMRC have suddenly realised they have been losing out and higher rate taxpayers who get 40% tax relief on their contributions have been benefiting, so they have decided to split the tax bands.
Now if a person has a refund worth up to £10,800 they are taxed at 20%, but if the lump sum refund exceeds this limit then they have to pay 40% tax on the excess amount of money.
And in addition HMRC have altered the way in which interest paid on a lump sum is taxed. According to Vahey, previously the lump sum refund and any interest paid to show the return it would have received if invested in another savings vehicle, was paid together in one sum.
However HMRC has decided to separate the two parts, so the lump sum refund is paid and taxed by the scheme administrator at either 20% or 40%, but the interest has to be paid gross to the member, and then it is up to them to inform HMRC of any tax they owe through their self-assessment.
But as Vahey points out, a lot of members who are part of defined contribution occupational pension schemes for less than two years will not normally have a self-assessment form, in which case they have to ring up HMRC and sort it out with them directly.
She says advisers should be aware of these changes, as it means they will need to let people know if and when they have to inform HMRC of any extra tax they owe when they receive a lump sum refund.
Although Vahey points out as the amount of tax on any interest is likely to be tiny, this change in procedure, where the refund of contributions and the interest is taxed separately, has increased the administration cost and burden for both schemes and individuals, with a very marginal benefit to HMRC.
She adds: “This is yet another illustration of HMRC changing things so the process has gone from something which was fairly simple and straightforward into something convoluted. It is just another example which proves pension simplification is anything but.”
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