What caught my eye this week.

Exciting news! Well, exciting as measured on our patented Government Bond Excitement Scale, anyway.1

The Financial Times reports that retail investors can now buy brand new gilt issues on the primary market, thanks to an initiative between government-appointed dealer Winterflood Securities and two online retail platforms – Interactive Investor and Hargreaves Lansdown.

The FT says that:

The platforms have started accepting orders for a seven-year gilt that will be issued on Wednesday 28 February with a coupon of 4 per cent. Retail investors will be given the average price of the auction and will not have to pay any dealing fees, unlike for gilts bought through platforms in the secondary market.

Some sites are saying this is the first-time that ordinary oiks like us have been able to buy gilts direct, but I don’t think that’s correct.

You definitely used to be able to buy gilts from the Government’s Debt Management Office. And I’m sure I recall reading that you could also once get them from other places too, from NS&I to the Bank of England – and even the Post Office?

Could any readers even more ancient than me confirm (Increasingly hapless Google isn’t showing me anything about buying gilts from Ye Olden Times of more than a few years ago.)

Soft launch

I haven’t seen anything on the two platforms themselves about how direct gilt buying will work.

An article from FI Desk quotes Hargreaves Lansdown outlining a summary of the process. But I can’t find the same on the site itself.

I’m sure the FT isn’t hallucinating, Chatbot AI style, so again, if you did put an order in please tell us all how it went in the comments below.

Assuming everything works fine, then buying gilts direct will hopefully become just another standard bit of kit in our investing armoury.

There are circumstances where buying gilts new and holding them until they mature is just the ticket. Being able to do so without fees would be welcome.

Shouting “buy, buy, buy!” as you rub shoulders with the big, swinging bond dealers in the primary market will remain purely optional.

Membership update

The Monevator membership massive continues to swell. We’re now within a dozen sign-ups of our initial target!

Hopefully waverers will join us soon. I think we’ve proven we’re sticking around, nearly a year in…

On that note, a reminder members can read all of our previous Mavens and Moguls missives via the ‘tagged’ archives:

• Mavens articles
• Moguls articles

Having recurring membership revenue at our backs makes it so much easier to commit to Monevator for the long-term. That’s especially true as our churn rate (cancellations) is very low.

Thank you for that too! I know this is partly because you’re signing up to support all our work on Monevator, not just for the premium articles. It’s appreciated.

The other relief is the technology – Stripe payments, subscription handling, and premium site access – has gone extremely smoothly.

However I am still occasionally donning my customer support hat:

• Cookie monsters: If you log-in as a member but still can’t access members articles, try deleting your cookies. Also turn off ad blockers for Monevator (the site is ad-free for members anyway). And maybe try clearing your cache.
• Premium emails: The numbers tell me a very few members are not email subscribers. In most cases this happens because you previously cancelled a Monevator email subscription. If you would like to get member posts by email and you don’t, try resubscribing. Be sure to look out for the system’s opt-in confirmation email.
• Bug busting: Finally, at least one member did that but a glitch meant they were only getting the free emails, not the members-only ones. If that’s happening to you, let me know by replying to this email or via the contact form. We can get it sorted.

Again, huge thanks to the several hundred of you supporting this site as members.

It’s the only long-term sustainable future for Monevator, and I believe for most other quality niche media. Every member counts.

Besides, we don’t want my FIRE-d co-blogger The Accumulator’s Werther’s Originals budget to be entirely at the mercy of sequence of returns risk, do we?

Have a great weekend!

[continue reading…]

1. This scale runs from ZIRP-ishly somnolent at the low end to Mini Budget Mayhem at the peak. [↩]

A lot of people confuse tax avoidance and tax evasion. It can be a dangerous mistake to make.

As the former British Chancellor of the Exchequer Denis Healey once said:

“The difference between tax avoidance and tax evasion is the thickness of a prison wall”.

That was why in the original published version of this article I stated:

• Tax avoidance means using whatever legal means you choose to reduce your current or future tax liabilities.
• Tax evasion means doing illegal things to avoid paying taxes. It’s the Al Capone path to financial freedom.

However the authorities have taken an increasingly tough line in recent years.

Now the phrase ‘tax avoidance’ may imply something much more questionable, as opposed to simply filling an ISA.

Tax avoidance might not be legal. Depending.

In particular, a General Anti-Abuse Rule (GAAR) was contained within the Finance Act 2013. This sought to counter ‘tax advantages arising from tax arrangements that are abusive’.

You should definitely delve into detailed guidance on GAAR if you’re contemplating doing anything out of the ordinary.

But the most relevant point for our discussion of evasion versus avoidance is that according to the tax planning resource RossMartin.co.uk:

In addition to the legislation, HMRC published guidance in April 2013 which expressly states that the GAAR is an intended departure from the previous situation where routinely cited court decisions such as the judgment of Lord Clyde, ‘every man is entitled if he can to order his affairs so that the tax attracted under the appropriate act is less than it otherwise would be’ are now rejected.

The guidance sets out the Parliamentary intention that the statutory limit on reducing tax liabilities is reached when arrangements are put in place which go ‘beyond anything which could reasonably be regarded as a reasonable course of action’.

And here’s what the Tax Justice Network says about the difference between avoidance and evasion:

Tax avoidance cannot be called ‘legal’ because a lot of what gets called ‘tax avoidance’ falls in a legal grey area. ‘Tax avoidance’ is often incorrectly assumed to refer to ‘legal’ means of underpaying tax (such as using loopholes), while ‘tax evasion’ is understood to refer to illegal means.

In the real world, however, this legal-illegal distinction often falls apart.

Whether an activity is legal or not often does not become clear until it has been challenged in court, and much of what gets called ‘avoidance’ turns out to be more like evasion.

As a result the Tax Justice Network – a lobbying group that focusses on states’ getting their due share of tax receipts – now favours the phrase ‘tax abuse’.

Tax avoidance may not be a criminal act then – depending. But if you’re hit with a big bill and penalties because what you did was deemed by a court to be the unacceptable face of paying less tax – ‘unreasonable’, in other words – then you may wonder if there’s a difference.

Please note I am NOT a tax expert and this article is not tax advice. It is simply the musings of a private investor trying to do the right thing with my own affairs. Consult a specialist and/or HMRC to know exactly where the law and you stand in respect to your taxes.

Tax avoidance out. Tax mitigation in.

For any criminals who Googled ‘tax evasion’, I’m not about to give you a masterclass in laundering cash or doctoring a passport.

I’ve never evaded taxes. I don’t condone it, and I couldn’t tell you how it’s done.

But tax avoidance mitigation – as we should now call it – is another matter.

The previous version of this piece already predicted taxes would rise in the UK over the next few decades. Higher pension costs, public debt, and the ever-rising bill for funding public services made that nailed-on.

Since then though we’ve seen public sector borrowing soar due to the pandemic, pulling forward this pressure. The overall level of taxes is now forecast to hit the highest level since the Second World War:

Our stagnant post-Brexit economy means it’s unlikely faster economic growth will bail us out anytime soon. Living standards will remain moribund, regardless of what party in power.

Meanwhile politicians increasingly talk about closing tax loopholes. In some cases – such as the carried interest enjoyed by private equity that’s now in the crosshairs of shadow chancellor Rachel Reeves – these are not improper, just disagreeable to a State with an insatiable appetite for more revenue.

Against this backdrop, it makes sense for investors to legally do what we reasonably can to reduce our tax burden – without overly compromising on other aspects of our lives, I’d suggest. (As opposed to be following the example of 1970s tax exiles…)

In doing so, we need to be extra careful today to follow the spirit as well as the letter of the law.

Examples of legitimate tax mitigation steps

There’s plenty you can do to reduce your taxes without risking fines or jail time.

ISAs and pensions

Most people can do all their investing entirely within tax shelters such as ISAs and SIPPs. They will not have to worry about further tax mitigation with respect to their investment returns.

VCTs and EIS schemes

These are riskier and (worse) more expensive ways to invest. But they can have a role for wealthy investors who’ve filled their tax shelters and can afford to chance lousy returns. Especially if they particularly enjoy backing new companies.

Think about who owns your assets

If you’re a married high-earner, it may make sense for your lower-earning and more lightly-taxed spouse to own certain assets and book the returns. Make the best of your family’s various personal allowances,  but maybe take advice if you feel you’re contemplating anything unusual.

Consider salary sacrifice and other steps to lower income tax

The aim is to defer paying taxes until you’re earning less in retirement, and thus will be taxed at a lower rate.

Taxing taxes

I’m confident those tax mitigation methods are fully within the spirit of the law. That’s because when you invest in an ISA, say, you are doing exactly what the legislation intended – enjoying a tax break given as an incentive to invest for your future wealth.

But once you – or your advisors – start to get creative, you roll the dice.

When I first wrote about tax avoidance versus tax evasion in 2009, it seemed like a less contentious subject.

Of course, nobody liked a tax evader, then or now.

But over the past decade or so – perhaps spurred by the popular backlash that followed the financial crisis, and boosted by the cost of living crisis more recently – politicians, the media, and the public have cast a harsher eye on even seemingly legitimate tax avoidance, too.

This has made the distinction between evasion and avoidance blurrier than it was.

Yet this is not really a new issue. Writing in the Financial Times in the wake of a controversial craze for tax inversions by US companies, John Kay noted:

It is conventional to distinguish legal tax avoidance from illegal tax evasion. But the reality is that there is a spectrum.

The person who avoids the heavy taxation on cigarettes by giving them up wins our approval; the gangmaster who employs illegal workers off the radar screen of government authorities goes to prison when detected. But most cases lie in-between.

The UK’s HM Revenue & Customs has issued big payments claims to people who invested in highly artificial film finance schemes that did not qualify for the allowances they claimed.

Were they avoiders or evaders? The line between avoidance and evasion would be clear only if the law were clear, and it is not.

Tax law is complex and the legality of particular actions can be firmly established only if there is a decision by a court on the facts of a particular case.

A tax avoidance horror story

The fate of the film financing schemes in the courts since Kay wrote his piece has had as many plot twists as any movie. Like most people not directly involved, I lost track.

I do know though that a Supreme Court ruling in 2017 ultimately found for HMRC – potentially recouping £1 billion for the nation’s coffers, albeit at potential ruin for users of the schemes. Some of them reportedly faced tax bills several times larger than their original investment.

An HMRC spokesperson was quoted as saying:

Avoidance schemes are often highly contrived and almost invariably fall flat when trying to deliver a tax advantage never intended by Parliament.

The fact is the majority of schemes simply don’t work and can put avoidance users in a significantly worse financial position than if they had never used the scheme in the first place.

Even MPs got involved in the drama, pushing back against court rulings – or at least on the penalties imposed.

In a letter to then-chancellor Philip Hammond, Andrew Tyrie, chairman of the Treasury committee, agreed the original film industry tax breaks were arguably “too generous and ill-defined.”

But with respect to rulings against the schemes designed to exploit those breaks, Tyrie added:

An increasing number of representations have been made to me expressing concern that the outcomes are not always fair nor what anyone could have expected.

This has resulted in financial calamity for some of those involved and considerable difficulties for HMRC in bringing a large number of schemes to a close.

The affair was still rumbling through the courts as late as May 2023.

Better know better

These film financing vehicles were marketed some 20 years ago. But the saga illustrates very well that what may seem a clever wheeze one moment can levy a heavy price in time.

Most Monevator readers will have little sympathy with multi-millionaire celebrities apparently going out of their way to avoid paying more taxes to fund schools and hospitals and the rest of the laundry list.

And I am certainly not saying the film schemes were legitimate. The courts have found they were not.

However there’s a bit of going somewhere but for the grace of God about it all.

Those celebrity investors were presumably mostly advised by specialists. I suppose that many just assumed the schemes were above-board.

After all, it took a very long-running court case to prove they weren’t. How was a footballer or a pop star supposed to be able to assess that, when presented with the scheme by a professional person in a suit?

Compensating factors

Consider, by way of comparison, the Payment Protection Insurance mis-selling scandal. By the end the banks had paid out nearly £40 billion in compensation to customers deemed to have been mis-sold PPI.

For these PPI ‘victims’, caveat emptor did not apply. They eventually got their money back.

But for the would-be tax-avoiding film financiers, caveat emptor has bitten them on the bottom line.

How would we feel, if formerly commonplace practices such as pension recycling or bed and ISA-ing were suddenly deemed too aggressive?

And we were then hit with a retrospective tax bill?

Exactly.

I’m just thinking aloud. Again, I’m far from an expert on tax matters. We never give personal advice on Monevator, for both practical and regulatory reasons. But I’m always extra wary when it comes to tax.

The fact is that tax matters are often very complicated. And often dependent on your personal situation.

The letter of the law

Interestingly, in the original version of this article posted in 2009, I quoted evidence of an emerging debate about the terminology as then covered on Wikipedia.

At the time the phrase ‘tax avoidance’ was apparently in dispute in the UK, with ‘tax mitigation’ being suggested as a better term for legal tax reduction.

The Wikipedia article noted, in paragraphs since removed, that:

The United Kingdom and jurisdictions following the UK approach (such as New Zealand) have recently adopted the evasion/avoidance terminology as used in the United States: evasion is a criminal attempt to avoid paying tax owed while avoidance is an attempt to use the law to reduce taxes owed.

There is, however, a further distinction drawn between tax avoidance and tax mitigation.

Tax avoidance is a course of action designed to conflict with or defeat the evident intention of Parliament.

Tax mitigation is conduct which reduces tax liabilities without “tax avoidance” (not contrary to the intention of Parliament), for instance, by gifts to charity or investments in certain assets which qualify for tax relief. This is important for tax provisions which apply in cases of “avoidance”: they are held not to apply in cases of mitigation.

I wrote at the time that: “I suspect this is largely a courtroom debate, caused by the Revenue looking to close down schemes of dubious legality created by planners for wealthy individuals.”

And indeed, that does seem to have been the direction of travel in this area, given that later ruling in the 2013 Finance Act.

Avoid being deemed an overt avoider

So where does this leave us?

As I say I’m no legal expert nor a tax planner. I’m just an everyday bloke who enjoys investing.

So to be absolutely clear, whenever I’m talking about reducing taxes on your investments, I mean by using legal and strictly above board means. Never the dodgy stuff.

But perhaps this isn’t enough anymore? Maybe we should apply the ‘seen on the front of the local newspaper’ test to any decisions we make when reducing our taxes?

In other words, how would you feel if whatever tax mitigation decision you made was splashed on the cover of your local newspaper? For all your friends and neighbours to read?

Saving into a pension? Putting money in an ISA? Making use of capital losses by setting them against capital gains to reduce your total taxable gain?

All very safe.

What about defusing capital gains over the years by making sure you use your capital gains allowance? Or incorporating your business to reduce your income tax bill and national insurance liabilities?

Already in the current climate we can see they seem a bit less safe. I think though they are still firmly on the right side of the spirit and reality of the law, if not always the court of public opinion.

What about offshore vehicles? Or using complicated company structures or loans to avoid payroll taxes or to disguise renumeration?

Hmm. I wouldn’t and HMRC would agree.

And as barrister Patrick Cannon notes on his website:

 …if HMRC investigate and find evidence of dishonesty or cheating then you may be looking at a criminal investigation for tax fraud and prosecution, leading to a prison sentence and a fine.

The sort of behaviour that this might cover includes claiming that genuine loans were made as part of the scheme when they were not genuine; or the writing of fake work diaries showing the taxpayer having spent time in the business when they were elsewhere. In my experience, these fake diaries are often produced by the scheme promoters and sent to the users for signature.

Avoid getting involved in anything dodgy or complicated like the plague. Jail sucks.

In fact, I personally draw the line at the vanilla tax mitigation I mentioned above. Beyond those straightforward measures, pay up and be happy you have the means to do so.

How to spot avoidance in action

In any event, it seems ‘avoidance’ has become a dirty word – at least when applied to contrived arrangements designed simply to reduce your tax bill.

More official advice from HMRC:

How to identify tax avoidance schemes

Here are some of the warning signs that you might be in a tax avoidance scheme or you are being offered to join one.

It sounds too good to be true

It almost certainly is. Some schemes promise to lower your tax bill for little or no real cost, and suggest you do not have to do much more than pay the scheme promoter their fees and sign some papers.

Pay in the form of loans or other untaxed payments

Some schemes designed for contractors, agency workers and other temporary workers or small and medium sized employers, involve giving workers some or all of their payment either as a loan or other payment that they’re not expected to pay back.

The payment may be diverted through a chain of companies, trusts or partnerships often based offshore and received from a third party. Sometimes the payment is received directly from an employer.

Other ways in which these untaxed payments may be described include:

• grants
• salary advances
• capital payments
• credit facilities
• annuities
• shares and bonuses
• fiduciary receipts

In all cases the schemes promise to put money in a workers pocket without having to pay tax on it. These schemes are often sold by non-compliant umbrella companies.

Huge benefits

The benefits of the scheme seem out of proportion to the money being generated or the cost of the scheme to you. The scheme promoter will claim there’s very little risk to your investment.

Round in circles or artificial arrangements

The scheme involves money going around in a circle back to where it started, or some similar artificial arrangement where transactions are entered into which have no apparent commercial purpose.

Misleading claims

The scheme is advertised using misleading claims. These may include claims suggesting a scheme is endorsed or approved by HMRC or that a scheme can increase your take home pay. For example:

• ‘HMRC approved’
• ‘Retain more of your earnings after tax’
• ‘We ensure you get the highest take home pay’
• ‘Compliant tax efficient pay’

These statements are likely to be misleading. HMRC does not approve tax avoidance schemes.

HMRC has given it a scheme reference number (SRN)

If HMRC has identified an arrangement as having the hallmarks of tax avoidance and are investigating it, you will receive an SRN by your promoter and you should include this on your tax return.

If an arrangement has an SRN, this does not mean that HMRC has ‘approved’ the scheme. HMRC does not approve any tax avoidance schemes.

If an arrangement does not have an SRN, this does not mean that the arrangement is not tax avoidance and could still be investigated.

Non-compliant umbrella companies

Many umbrella companies operate within the tax rules, however, some umbrella companies promote tax avoidance schemes. These schemes claim to be a ‘legitimate’ or a ‘tax efficient’ way of keeping more of your income by reducing tax liability.

Find out what to do if an umbrella company offers to reduce your tax liability and increase your take home pay in Spotlight 45.

Schemes HMRC has concerns about

You can find examples of tax avoidance schemes HMRC is looking at closely. Even if a scheme is not mentioned, it may still be challenged by HMRC.

You might also find HMRC’s report on the use of marketed tax avoidance schemes worth reading if you have reason to want to know more.

If in doubt, pay the tax

Well, there you have it. I know I haven’t done anything dodgy – my affairs are far too boring, and after years of defusing capital gains, nearly all my investments are these days in tax shelters or else qualify for EIS exemption.

I hope you haven’t strayed either. But the woeful fate of the film financing schemes shows how even wealthy and professionally advised investors need to be careful and remain vigilant.

Thoughts and corrections welcome in the comments, especially from experts.

Let’s be careful out there.

I have always found it hard to keep a grip on the pension drawdown options. There are so many fiddly yet peskily important details to forget about.

So today we’ll try to capture all the crucial drawdown details in one place for future reference.

Let’s take it one step at a time…

What is a drawdown pension?

Going into pension drawdown is one of the options you have when taking money from a defined contribution pension of some description.

Defined contribution pensions have more aliases than a criminal mastermind, including:

• Personal pension
• Workplace pension
• Occupational pension
• Stakeholder pension
• SIPP
• Master trust pension

There’s even more out there if you look for them!

Meanwhile, a defined contribution pension is best described as not a defined benefit pension.

A defined benefit pension offers you a guaranteed income for life.

A defined contribution pension does not, and so is not as good. It is however typically cheaper and less burdensome for a company to offer to its workers than a defined benefit jobbie. Which is why defined benefit pensions are nowadays rarer than unicorn milk in the private sector.

If you’re under 60 and you work in the private sector, you most probably have a defined contribution pension.

This article focuses purely on your options if you hold a defined contribution pension. Mostly because that’s the type I have too – and because I have to draw the line somewhere.

I’m also going to assume that the earliest you can retire is age 55 (going up to 57 from 6 April 2028) and that you don’t have any other pension bells and whistles like lump sum protections and the like.

We can investigate the exceptions and edge cases together in the comments.

Pension drawdown: take a step back to go forward

When you crack open your pension pot, you can take some of your savings as tax-free cash (TFC)1 – which is every bit as good as it sounds.

The rest of your income needs are serviced by taxable cash.

There are three main options for releasing the taxable wedge from your pension, and we’ll come to those in a sec.

How much tax-free cash?

You can take up to 25% of your pension savings as tax-free cash.

Your tax-free cash is currently capped at £268,2752 (known as the lump sum allowance) or 25% of the lump sum and death benefit allowance (LSDBA) of £1,073,100.3

You can take your entire tax-free cash allowance in one go, or in stages. It’s up to you.

Options for your taxable pension savings

For every £1 you take in tax-free cash, you have to decide what to do with the other, potentially taxable £3:

Pension drawdown – you can take a flexible income from your pot while the rest of your funds are typically left invested.

Buy an annuity – you hand over a sizeable chunk of your loot to an insurance company. It then pays you a regular income for as long as you wear this mortal coil.

Cash grab – you can take your entire pension as cash NOW. Or some of it. This is the Lamborghini option. Or a Vauxhall Corsa in my case. HMRC will send you a birthday card if you go down this route. Sorry, that should read enormous tax demand.

Have it your way – mix-and-match the three options above, in any combination you like, Burger King-style.

Your provider may not offer all or even any of these options. In which case you can transfer your pension to someone who will.

Okay, I’d love to talk about pension drawdown now. But, to do that, I’ve gotta get some more confounding terminology out of the way…

Crystallised versus uncrystallised pension

There’s no escaping this.

Your pension stands astride a boundary. Not the line betwixt good and evil but between uncrystallised and crystallised.

Uncrystallised pension savings refer to pension assets that are not ‘in play’. They remain invested in your pension pot, poised in a superposition. All options are still on the table, because you haven’t yet entangled them in a withdrawal event. [Editor’s note: Great thinking @TA – using a quantum mechanics metaphor to simplify pension chat!]

Crystallised pension savings are assets that are ‘in play’ because you’ve withdrawn money.

For example imagine you withdraw 10% of your £500,000 pension as tax-free cash.

This crystallises £200,000 like so:

• £50,000 in tax-free cash
• A further £150,000 of pension savings that require you to select from the options described in the previous section. (This is the taxable £3 bound up with every £1 of tax-free cash you took).

To recap: your remaining £150,000 of crystallised funds can be put into drawdown, some portion can be used to buy an annuity, or you can stuff the lot into a holdall before going on the run from HMRC.

All that means that £300,000 of our original £500,000 pension is still uncrystallised. And 25% of that £300,000 can still hatch as tax-free cash.

Crystal clear-ish

Perhaps the best way to think of the metamorphosis between uncrystallised and crystallised pension is that income is taken from the crystallised portion and may be subject to income tax at your marginal rate.

Lots of sources describe crystallising pension assets as ‘cashing in’ your pension. This doesn’t make sense to me. You can leave crystallised funds invested and untouched for the rest of your life if you want.

Importantly, when you crystallise an amount, you lose your right to its associated 25% tax-free cash if you don’t take it at the time.

Incidentally, your pension is not subject to Inheritance Tax – no matter which state it’s in.

Pension drawdown rules

At last! With that foundation course out of the way, we can move on to the actual pension drawdown rules.

Pension drawdown is extremely flexible, subject to the confines of your provider’s scheme.

If you take 25% of your pension pot as tax-free cash then the remaining 75% can be put into drawdown as discussed.

From there, you can start taking an income from these crystallised funds. As frequently as monthly if your broker’s particular platform is game.

That’s one way of doing it.

However a better way for many people is to periodically take tax-free cash in chunks. For example, in amounts that don’t exceed your annual ISA allowance, so you can then tuck the cash away in an ISA where it can continue to grow tax-free.

This approach is known as phased drawdown or partial drawdown, because every tax-free withdrawal also crystallises additional assets in the 3:1 ratio described above.

Phased or partial drawdown

Phased drawdown isn’t a special pension drawdown mode you need to unlock. It’s just a name given to drawing down in stages, as opposed to taking all of your tax-free cash in a one-er.

Here’s an example of phased drawdown:

I’ve streamlined this example. There’s no need to crystallise the same amount every year with phased drawdown.

I’ve not stuck to my sustainable withdrawal rate in this example either. And it illustrates a mild investing nightmare, as the portfolio has gone sideways for two years on the trot.

Remember that any amount of the £30,000 crystallised segment can be taken as income too (or none of it), but these withdrawals are subject to income tax once you’ve smashed through your personal allowances.

Phased drawdown has two advantages versus the other method of withdrawing from your pension in stages: the uncrystallised funds pension lump sum (UFPLS).

Firstly, phased drawdown doesn’t trigger the Money Purchase Annual Allowance (MPAA) rules. Just so long as you don’t take an income from your crystallised funds.

In other words, you won’t limit tax-relief on your future pension contributions if you can live off your tax-free cash and/or other income sources for a time.

Secondly, tax-free cash from drawdown isn’t restricted to 25% of the standard limit if you have pension protections that exceed that limit.

Capped drawdown

Capped drawdown was a more restrictive set of pension drawdown rules that applied before the shackles were loosened.

You can’t choose capped drawdown as an option anymore. You can decide to remain on it though.

Pension drawdown tax

Any money withdrawn from your pension drawdown assets (aside from your tax-free cash) is subject to income tax as normal.

These withdrawals count as non-savings income that is taxed in the same way as wages from a job.4

The first £12,570 taken from your pension drawdown balance is tax-free due to the personal allowance. All the usual tax bands and rules apply thereafter.

Treat the family by dying before age 75

If you die before age 75 then any beneficiary can take an income from your drawdown pension tax-free. This is known as beneficiary drawdown but it isn’t available from all schemes. The same goes for annuities.

If you die before age 75 then any lump sum payments in excess of the lump sum and death benefit allowance are taxable at your beneficiary’s marginal income tax rate.

After age 75, all payments are made at the beneficiary’s marginal income tax rate.

Obscure exception 1: Income tax is payable at the beneficiary’s rate if you die before age 75, and payments are taken from uncrystallised funds that are not designated for drawdown within two years of the scheme administrator knowing about your death.

Obscure exception 2: Income tax is payable at the beneficiary’s rate if you die before age 75, and a lump sum is taken beyond two years of the scheme administrator knowing about your death.

Obscure exception 3: Income tax is payable at 45% on lump sums paid into a trust, if you die after age 75.

Note: Taking income from an inherited pension does not trigger the Money Purchase Annual Allowance.

Emergency tax on pension drawdown payments

Tax on pension withdrawals is deducted by your broker/scheme provider using PAYE.

Your first drawdown payment (or any that are deemed to be ad hoc) is likely to be taxed using an emergency tax code rather than your actual rate.

Look out for an ‘M1’ suffix on your tax code e.g. 1257LM1.

This indicates your payment is taxed on a Month 1 basis.

The M1 means HMRC will multiply that payment by twelve as they assume that you’ll receive the same amount of income every month.

For instance, if you take £20,000 (above and beyond your tax-free cash) to cover the year, HMRC will calculate that you must be living it large on a £240,000 annual income.

Obviously paying tax at that rate is going to take a massive bite out of your £20,000 income apple. It could be months before you’re refunded by HMRC.

It’s a patently ludicrous situation.

You can reclaim the tax (see below) but that takes time.

Cracking the code

After that initial tax bill shock, you’re on HMRC’s pension payment radar. They should issue you (and your pension provider) with a tax code that’s based on how much tax you’ve already paid this tax year.

Now you’re being taxed on a cumulative basis, which is how we’re all used to being treated when we’re paid a monthly salary.

A standard tax code like 1257L shows you’re being taxed on a cumulative basis i.e. the M1 has been lopped off.

With a cumulative basis tax code in play you should be taxed properly on any regular withdrawal schedule agreed with your pension provider.

So if they offer you payments on, for example, a quarterly or annual regular withdrawal schedule, HMRC should tax those on the basis that they amount to 25% or 100% of your annual income.

Any under or overpayments of tax will be clawed back or refunded through your future regular income drops, and HMRC will automatically issue new tax codes to your provider to make it so.

As mentioned, ad hoc payments are always treated on an M1 basis, so they have the potential to knock things sideways tax-wise.

Quilter has provided an excellent explanation of how pensions and PAYE interact. Many thanks to Monevator reader Tricky for linking to this in the comments.

Deescalation

I’d recommend having a conversation with your broker about how you can duck the emergency tax bullet – but it seems to be unavoidable because this is how PAYE works.

There do seem to be two ways to mitigate the tax hit on your first pension payment:

• If you plan to take a regular drawdown income then ensure your first taxable payment is only for a small amount – such as £100. The emergency tax rate will apply to this amount and HMRC will then issue updated tax codes that adjust for your subsequent, larger payments throughout the tax year.

This way, HMRC is effectively reclaiming the correct amount of tax from you. There’s lovely!

• If you’ve been issued a P45 for the same tax year as your first drawdown payment then ask your broker if that will enable them to apply an accurate tax code from the start.

Choosing your regular income schedule

Perhaps your broker manages their system on a VIC-20, or you want payments aligned with the lunar months?

Either way, your pension provider may not be able to provide you with a satisfactory schedule of regular payments.

In that case, my personal preference would be to sell down enough bonds and equities to cover myself for the time period in question e.g. a year. Then I’d park the cash in my pension – possibly using a money market fund if my broker’s interest rate is rubbish. Finally, I’d take monthly payments (or whatever schedule the provider can offer) from that cash balance to keep things square with HMRC.

Relatedly, Monevator reader Gizzard points out that some lenders will only look at monthly income payments when assessing your credit worthiness. So your clockwork annual payments may get disregarded as ‘unusual’ lump sums.

Reclaiming tax

Just for fun, HMRC have three different tax forms on the go for reclaiming tax on pension withdrawals. Choose from:

• P55 – if your withdrawal hasn’t emptied this particular pension and you don’t intend to take any more payments from it this tax year
• P50Z – if you’ve drained this pension dry and aren’t working
• P53Z – you’ve tapped out this pension and are still working

When you plan to take multiple withdrawals from a pension then HMRC will revise your tax code later in the year for under/overpayments. Thus we’re spared another tax form.

Pension drawdown charges

You shouldn’t have to pay anything for drawdown services these days.

See the SIPP row / Fee notes column of the Monevator broker table to find drawdown and UFPLS fees.

Fidelity, AJ Bell, Aviva, and Hargreaves Lansdown all charge nothing for drawdown. And they cap their platform charges at a reasonable rate if you choose an ETF-only portfolio.

Small pots

The small pots rule allows you to empty three defined contribution pensions worth up to £10,000 each but with two additional bonus features that you may wish to know about.

Firstly, the small pots rule works like the cash grab option we described earlier:

• You can withdraw all the cash from any of your pensions in one go
• Up to 25% is available as tax-free cash
• The remaining funds are subject to income tax as usual

However, you must empty a small pot completely when using this rule. You can’t leave the money hanging around, so watch out for any tax consequences that follow from withdrawing your 75% taxable cash.

The two small pots bonus features are:

• It doesn’t trigger the MPAA limit that caps tax relief on future pension contributions.
• Small pots’ 25% tax-free cash does not use up any of your normal tax-free cash because small pots aren’t tested against the lump sum allowance.

So you may be able to rearrange your pensions to squeeze out another £7,500 in tax-free cash using small pots.

Check with your pension provider to ensure your scheme is eligible for the small pots rule.

You may well pay the wrong amount of tax initially on a small pots withdrawal as the basic rate is automatically applied to the taxable element – regardless of any other tax you’ve paid in the year.

The rules are different if your defined contribution scheme is classified as an ‘occupational pension’ scheme, although few are, apparently.

Pension Wise

Finally, if you would welcome advice on how to make the most of your pension then know that you are entitled to a free Pension Wise advice session.

Doubtless even grizzled Monevator mavens would benefit from the chance to clarify things. You can also attend an appointment on behalf of a family member or a friend.

Given the life-changing nature of these decisions, I’m very glad that Pension Wise exists to offer a guiding hand. Even if only for 60 minutes.

As for us, that’s it for our tour of the pension drawdown rules.

Complexity seems to be the necessary by-product of the UK’s flexible pension system. I hope this piece goes some way to clearing up the fug surrounding it.

But let us know what we’ve missed in the comments below.

Take it steady,

The Accumulator

PS – check out HMRC’s pension tax manual if you’re having trouble sleeping at night.

1. Also known as the pension commencement lump sum or PCLS. [↩]
2. Unless you’ve already locked-in a higher lump sum or lifetime allowance limit. [↩]
3. The pale shadow of the Lifetime Allowance. [↩]
4. Though pension withdrawals do not count as earnings that determine how much you can contribute towards a pension. [↩]