Over 55s who overpaid income tax when they withdrew money from their pension savings have been refunded more than £26m in just the past three months, new figures from HMRC have revealed.
Thanks to a quirk in the tax system, people on modest incomes could end up paying the top 45% tax rate on the first lump sum they withdraw from their savings under the pension freedoms rules.
This is because pension companies apply an emergency tax code to your first withdrawal, which assumes the lump sum you’ve withdrawn is 1/12th of your annual income.
This means that someone making a relatively small withdrawal of £20,000 could be taxed as though they earned £240,000 a year.
More than £26m pension tax repaid
Figures from HMRC show that, between 1 April and 30 June 2017, a total of 10,576 claims for pension tax refunds were made, with £26.8m repaid – which suggests that, on average, people had overpaid tax by around £2,500.
Pension tax repayment claims are made through one of three forms – P55, P50Z or P53Z. Overpayments should be refunded within four weeks.
More than half of claims made were using form P55, which should be used by people who have withdrawn some but not all of their pension as a lump sum. Almost a third of claims were using form P53Z, for those who withdrew all of their pension savings in one go and are still working.
The remainder were made on a P50Z, for those who are no longer working and have withdrawn all of their savings.
You can find out more about reclaiming overpaid tax on gov.uk.
‘Month 1’ emergency tax – why is it applied to pension payments?
When you take a lump sum for the first time from your pension savings, your pension company will not know what your personal tax code is, or what income you have from other sources to correctly deduct the right amount of income tax from that payment.
Until it has this information from HMRC, it instead deducts income tax on a ‘Month 1’ basis, which assumes you’re receiving 1/12th of your total income for the year – even though it is a one-off payment. If you withdrew £20,000 from your pension, you’d be taxed as though you’ll earn £240,000 over the course of a year.
The knock-on effect of being taxed on a Month 1 basis is that just 1/12th of your annual tax-free allowance and tax bands are set against unusually higher amount, pushing you into a higher tax bracket. This breaks down to:
- The first £958 you earn is taxed at 0%
- The next £2,792 is taxed at 20%
- The next £9,708 is taxed at 40%
- Anything above £13,458 is taxed at 45%
In addition to this, you could lose some or all of your tax-free allowance, depending on how much you withdraw. Your tax-free allowance reduces by £1 for every £2 you earn over £100,000 a year and disappears completely once you earn £123,000 or more.
Being taxed on Month 1 basis means a withdrawal of £10,250 (1/12th of £123,000) would see you lose your entire £958 tax-free allowance for the month.
A £20,000 withdrawal could result in more than £7,500 take in income tax.
How many people may have overpaid tax on pensions?
In the same period that HMRC repaid £26m to just over 10,000 savers, 200,000 people withdrew a total £1.86bn from their pensions.
In May, we reported on research from pension company AJ Bell, which suggested that ‘tens of thousands’ of people may have overpaid tax on pension withdrawals without realising it. There are no official figures that show how many savers have yet to reclaim overpaid tax.
It seems that, unless the current system changes, there is little way to avoid being overtaxed on your first lump sum withdrawal from your pension.
In June, we investigated a tactic that involved withdrawing a small amount from your pension which was taxed on a Month 1 basis, and then making a second, larger withdrawal with the correct tax code. HMRC, howevet, was skeptical that this would work.
Even if savers don’t take any action to actively fill in the right forms to reclaim overpaid tax, HMRC will eventually refund any overpaid tax at the end of the tax year (5 April).