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‘Absolute disgrace’ as pension overtax system hits bleak £1bn milestone

Paloma Kubiak
Written By:
Paloma Kubiak

Pension savers have had to reclaim more than £1bn in overzealous income tax applied when accessing their pots for the first time, HMRC figures reveal.

Since the dawn of pension freedoms in 2015, savers have been forced to reclaim £1.01bn in overpaid tax when flexibly withdrawing their retirement money.

In the three months to 31 March 2023, more than £48.5m was repaid to 15,856 people who were overtaxed on pension withdrawals.

This figure is more than double the £22m repaid at the same time a year ago.

The latest quarterly statistics from HMRC are also the highest quarter one figures on record and the second highest of any three-month period since April 2015.

According to wealth manager Quilter, “this huge increase demonstrates the continued necessity for people to access their pension funds amidst the intensifying cost-of-living crisis impacting day-to-day financial situations”.

On average, people are withdrawing just over £3,000 each which although is slightly down on the previous quarter, it “suggests more people are accessing smaller retirement pots”, according to AJ Bell.

It added that as HMRC statistics only capture the total repaid from people who have actually reclaimed their money, the true figure could be much higher.

Pension overtaxation: Why does it happen?

Pension freedoms rules allow anyone over the age of 55 access to their pension pots with the first 25% being tax-free.

When someone takes their first ‘flexible’ withdrawal from their defined contribution pension (over £10,000, and over the 25% tax-free lump sum figure), providers apply tax on a ‘month one’ basis. This means the withdrawal is counted as if the same amount of money will be taken every month during the financial year, rather than viewing it as a one-off withdrawal.

The emergency tax rate applied is usually calculated on a much higher annual withdrawal than the pension saver actually takes.

Tom Selby, head of retirement policy at AJ Bell, explained: “Since 2015, the Revenue has chosen to tax the first flexible withdrawal someone makes in a tax year on a ‘month one’ basis.

“This means HMRC divides your usual tax allowances by 12 and applies them to the withdrawal, landing hard-working savers with shock tax bills often running into thousands of pounds.

“While those who take a regular income or make multiple withdrawals during the tax year should be put right automatically by HMRC, anyone who makes a single withdrawal will likely be left out of pocket.”

How to get your money back

It is possible to get your money back within 30 days if you fill out one of three HMRC forms otherwise it will be repaid at the end of the tax year.

To date, some 300,000 forms have been filled. If you are affected, fill in one of these three claim forms which can be found on the Government’s ‘Claim a tax refund’ page.

They include:

  • P55 – used by claimants when the payment didn’t use up the pension pot and individuals aren’t taking regular payments. It can only be used if a pension provider can’t refund you. HMRC received 9,654 claims in the three months to March 2023.
  • P53Z – used by claimants where the payment used up your pension pot and you have other taxable income such as if you’re working or receiving benefits. HMRC received 4,361 forms.
  • P50Z – used by claimants if the payment used up your pension pot and you have no other income in the tax year. HMRC received 1,841 claims.

It is possible that your pension provider may pay you back automatically. Otherwise, HMRC may post you a P800 tax calculation where you may be able to claim online or it will send you a cheque.

‘Scandal’ and an ‘absolute disgrace’

Steve Webb, former pension minister and current partner at pension consultancy Lane, Clark and Peacock, said: “This is an absolute disgrace. A system based on systematic overtaxing of pension savers cannot be right.

“There is no good reason why citizens who access their pension should have to go through the hassle of claiming back excess taxation which they should never have had to pay in the first place.

“Reform of the system is long overdue so that it works to the benefit of pension savers and not the Treasury.”

Selby added: “It is a scandal that Government has failed to adapt the tax system to cope with the fact Brits are able to access their pensions flexibly from age 55, instead persisting with an arcane approach which hits people with an unfair tax bill, often running into thousands of pounds, and requires them to fill in one of three forms if they want to get their money back within 30 days.”

He said while it is “good news” that people have received the tax they’re owed, people on lower incomes who are less familiar with the self-assessment process might be less likely to go through the official process of reclaiming the money they are owed.

“As a result, they will be reliant on HMRC putting their affairs in order.”

A tax workaround

Jon Greer, head of retirement policy at Quilter,  said: “For anyone looking to access their pension flexibly, it may be worth consulting a professional financial adviser who can help reduce the risk of paying excessive upfront taxes.

“For instance, by making multiple smaller pension withdrawals rather than a single lump sum. This can ensure that most of the withdrawal utilises an updated tax code, preventing emergency taxation on the full amount.”

Meanwhile, Andrew Tully, technical director at Canada Life, shared this tip to help pension savers avoid the tax: “For customers making a pension withdrawal for the first time, a workaround is to initiate a small withdrawal of say £100. That will generate a tax code from HMRC which the pension provider will apply to any subsequent withdrawals.”