Surge in long-term savings withdrawals exposes major flaws in the system

Britons trying to plug the financial holes inflicted by coronavirus are drawing cash from long-term savings that aren’t meant to be used as emergency savings accounts, pensions experts are warning, as punitive charges prompt an urgent change in the law.

Last week, John Glen, economic secretary to the Treasury, announced a minor-sounding tweak about an all-but-ignored kind of government-backed savings plan – the Lifetime ISA.

It is set up so that subscribers get a 25 per cent top-up, paid monthly, on up to £4,000 of savings each year, to help them either save for their first home or later life.

If you want to take the money out for a different reason, you’ll be charged 25 per cent of everything you take out, as a disincentive.

With everything else going on, the change would be an easy thing to miss – the removal of a 5 per cent withdrawal fee.

And it’s a sensible move in the circumstances. But as the nation scrambles for short-term cash, putting pressure on a system designed to facilitate traditional, predictable and linear long-term financial planning, the cracks are starting to show.

“[Lifetime Isas] were originally set up as a halfway house between a retirement savings vehicle and an Isa product for first-time buyers,” says Rachael Griffin, financial planning specialist at wealth management firm Quilter, who describes them as a muddled idea to begin with.

“It was an unusual experiment in blending pensions and young people’s savings into a single vehicle from the then-chancellor George Osborne, who was keen to explore alternatives to the traditional pension system. In the end that experiment has produced a botched job and now his successors are cleaning up the mess left behind.”

Lifetime Isas are neither an Isa, with the flexibility to withdraw money at any time, nor a pension, which has generous tax relief but requires savers to lock up their money until at least age 55.

“That has led to a situation where they have a penalty for early withdrawal similar to a pension,” Griffin adds. “But crucially, they are treated like an Isa for a means test assessment for universal credit. This means that if you apply for universal credit, your pension is not included as a potential source of income if you’re under 55 and face a tax penalty to access it. But a Lifetime Isa is treated like an Isa and so does count against you, even though it carries a tax penalty.”

The truth is that Lifetime Isas are the poor cousin to most long-term savings vehicles, with precious little uptake and few providers offering them.

A larger picture of problematic workarounds is emerging as more people dip into their pensions as a result of Covid-19.

Official figures from HMRC show Britons using the pensions freedoms rules to withdraw money from their retirement savings early have so far reclaimed £600m from the revenue due to an emergency “Month 1” taxation policy.

If someone makes a single pension withdrawal of £12,500 (the same level as the personal allowance) and has no other taxable income, they might expect to be taxed at 0 per cent.

But because Month 1 is applied, all their usual tax allowances are divided by 12. This means only a twelfth, or £1,042, of the withdrawal is taxed at 0 per cent.

Another £3,125 is taxed at 20 per cent. The remaining part of the withdrawal is taxed at a whopping 40 per cent.

In all, someone expecting to pay no tax at all is coming away with a bill of almost £4,000 that they need to them claim back. If they realise they can.

More than 10,000 official reclaim forms were processed by HMRC in the first quarter of 2020, with the average person getting a refund of £3,141.

“While the freedom and flexibility pensions now offer has been welcomed by millions, HMRC’s insistence on applying a ‘Month 1’ emergency tax code to the first withdrawal of the tax year has now seen savers reclaim £600m in overpaid tax,” says Tom Selby, senior analyst at AJ Bell, who adds that the true level of refunds could be far higher because these figures only include those claims made through the official forms rather than the tax year end refund system.

“Anyone planning to access their pension in the new tax year – including those looking to use their retirement pot to plug an income gap resulting from Covid-19 – needs to be aware of the impact Month 1 taxation will have on the amount of money they receive initially,” he warns.

“For those taking a regular stream of income, HMRC should automatically adjust your tax code so you receive the right amount in subsequent months.

“However, where you are making a single withdrawal in the tax year you will either have to fill out one of three forms or wait for the Revenue to sort out your tax position.”