Can this tactic help you avoid a huge pension tax bill?

Withdrawing a tiny amount of money from your pension could help you avoid a trap that has potentially caused thousands of people to overpay tax on their retirement savings.

If you withdraw a lump sum from your pension, your pension company deducts tax under the Pay As You Earn (PAYE) system. But when you do this for the first time, it applies an emergency tax codewhich assumes amountyou're taking is your monthly income - causing you to significantly overpay tax.

In April, we reported that tens of thousands of people may not be aware of this quirk, and that they could be failing to reclaim millions of pounds in overpaid tax. Former pensions minister Sir Steve Webb, now director of policy at insurer Royal London, told Which? Money this system of collecting tax from pensioners was 'draconian.'

But the Telegraph has reported that there may a simple way to avoid being hit with a huge pension tax bill, suggesting that all you need to do is withdraw as little as £1 from your pension to ensure the correct tax is taken from a second, larger lump sum.

But how does this 'trick' work? Which? Money finds out.

Emergency tax on pensions: why it happens

There are two ways of taking a lump sum from your pension.

The first is an 'uncrystallised fund pension lump sum' - where the first 25% of the lump is paid tax-free, and the remaining 75% is subject to income tax. Alternatively, you can take a lump sum through 'income drawdown', where it will all be taxable (as you'll have taken a 25% tax-free lump sum at the start).

When you take a lump sum for the first time, your pension company won't know how much income you have from other sources or what your personal tax code is. So, it will deduct tax on what's known as a 'Month 1' basis. This is an emergency tax code.

This assumes you're receiving 1/12^th of your total income for the year - a £10,000 withdrawal is assumed to be part of a £120,000 annual income, for example - and so only 1/12th of your annual tax-free allowance and tax bands are set against this amount. It's quite complicated, but we've broken this down in the table below.

If you're being taxed on a Month 1 basis, you could lose some or all of your £958 tax-free allowance. It is reduced by £1 for every £2 you earn over £100,000.

So, a withdrawal over £8,333 (1/12th of £100,000) would see your tax free allowance start to reduce, and it would disappear completely if you withdrew £10,250 (1/12th of £123,000) or more.

How much tax could I be paying on my pension?

The result of having your pension paid with an emergency tax code means that a relatively modest withdrawal could see you losing your tax-free allowance and becoming 45% taxpayer, when in normal circumstances you'd pay no tax, or only basic-rate tax.

Assuming you've got no income from other sources, and you use income drawdown to take money from your pension,being on an emergency tax code would see:

• A £10,000 withdrawal landed with a £3,058 tax bill
• A £20,000 withdrawal landed with a £7,385 tax bill
• A £30,000 withdrawal landed with a £11,885 tax bill
• A £50,000 withdrawal landed with a £20,885 tax bill
• A £100,000 withdrawal landed with a £43,385tax bill

We used Hargreaves Lansdown's emergency tax calculator to generate these figures.

Does making a small withdrawal from your pension fix this issue?

The emergency tax code is normally only used for the first payment from your pension. After that, HMRC will supply your personal tax code to your pension company and any subsequent withdrawals in the tax year should be taxed correctly.

So, if you only withdraw a small amount - as little as £1 - the emergency tax code will only be applied to that amount. Wait for another month to make the larger lump sum withdrawal you actually want and you should be taxed correctly.

We asked HMRC if it believed this worked in practice. It told us that it was an 'interesting concept' but that it was impossible to say for sure whether it would guarantee that you could avoid overpaying tax.

A spokesperson said that tax codes work over 12 months. As an example, it said that if someone 'withdrew £1 in April with the emergency code operated against it, HMRC might issue a revised code which could be operated against a larger withdrawal made in May.'

But because that is only month two of the tax year, only 2/12ths of the tax allowances and rate bands would be given against the payment.

If HMRC puts you onto 'cumulative' tax code, you could still overpay tax depending on how far into the tax year you make your second withdrawal.

Do pension companies let you take tiny amounts from your savings?

We spoke to two large pension providers. Kate Smith at Aegon said that this was a common issue, but customers using income drawdown in Aegon's Sipp could withdraw an ad-hoc payment of £1.

Steve Webb at Royal London, however, said that 'in practice most providers would apply a minimum withdrawal' higher than £1. With his firm a £1,000 minimum withdrawal applies in most cases, although this partly this 'reflects the typical size of the pension pots' Royal London handles, which tend to come from clients of financial advises with larger pensions.

Mr Webb said that 'the fact that people are having to find ways to get round HMRC's draconian approach suggests something is wrong with the system.'

How do I reclaim an overpayment?

Overpayments should eventually be refunded by HMRC, but the process could take months.

Instead, you can complete one of three online forms to actively claim a refund. HMRC says that this should take no longer than four weeks.

• P55 is for those who take out a some but not all of their pension as a lump sum
• P50Z is for those who take out all of their pension and are no longer working
• P53Z is for those who take out all of their pension and are still working