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Ask an expert: ‘Why has HMRC taken too much tax from my pension?’

Another reader hit by 'emergency' tax on their pension

Capital gains tax

Each week, the Which? Money experts answer your financial queries. You can submit your questions to money-letters@which.co.uk, or via our Facebook or Twitter pages.

Q. I’ve just turned 55 and decided to withdraw all £50,000 from an old pension, as is my right under the freedoms. But HMRC has taken more than £15,000 in tax, despite the fact that I’m only earn around £30,000 a year. Why has this happened?

Name and address supplied.


A. You’re certainly not the first person who has written to us having seen a big bite of your pension disappearing in tax when you’ve made a withdrawal. In fact, 106,000 people have been forced reclaim tax that has been incorrectly deducted from their pension.

Indeed, HMRC has had to repay more than a quarter of a billion pounds (£262m) to people who’ve taken a lump sum from their retirement savings using the pension freedoms – an average repayment of £2,454.

The majority of people (more than 48,000 since the freedoms were introduced) who’ve had to apply for a refund are in your position – those who have withdrawn all of their money from their pension but are still working.

So, why does this happen? It’s a quirk in the tax system that affects the first lump sum you withdraw from your pension, applying an emergency tax code to your pension withdrawal and causing you to overpay tax.

Here we explain why this happens – and what you need to do to claim back the tax you’ve overpaid.

Tax on cashing in your pension

When you decide to cash in your pension in its entirety, the first 25% you take is tax free. In your case, £12,500 was paid to you tax free.

Income tax is then deducted through the Pay As You Earn system by your pension company.

Given that your annual income from other sources is £30,000, you should have seen £38,000 paid out to you and £12,000 paid out in tax. This is worked out as follows:

  • £12,500 paid tax free;
  • £15,000 of the remaining £37,500 is taxed at 20%, resulting in £3,000 in tax. This is because you don’t pay tax at the higher rate of 40% until your income is above £45,000, and you have £15,000 left after your other income.
  • The residue, £22,500, is taxed at 40%, resulting in £9,000.
  • The total tax bill on your pension is £12,000

You can work out how much tax you should pay on a pension lump sum withdrawal using our calculator.


Emergency tax on pensions

Here’s where things go awry. When you made your withdrawal, your pension company did not know your personal tax code or how much you earned from other sources in the tax year. It has, therefore, deducted tax using an emergency tax code, known as ‘Month 1’.

As we explained when we covered this topic back in July 2017, Month 1 deductions assume that the pension you’re receiving is 1/12th of your total income for the year. In your case, a £50,000 withdrawal is assumed to be part of a £600,000 annual income – far from the reality.

Because of this, 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.

Tax-free/taxable monthly income Annual allowance/threshold
Amount on which no tax is paid Up to £958 Up to £11,500
Amount on which 20% tax is paid Up to £2,792 Up to £33,500
Amount on which 40% tax is paid Up to £9,708 Up to £116,500
Amount over which 45% tax is paid £13,458 and above £150,000 and above

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. 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.

So, your £50,000 withdrawal has caused you to lose your tax-free allowance and pay 45% a big chunk of your pension. It breaks down as follows.

  • £12,500 paid tax free;
  • £3,750 taxed at 20%, which results in £750 tax
  • £9,708 taxed at 40%, which results in £3,883.20
  • £24,042 taxed at 45%, which results in £10,818.90
  • Your total tax bill is £15,452, leaving you with £34,548

You’ve therefore overpaid tax by £3,452.

How do I reclaim an overpayment for emergency pension tax?

HMRC should evenutally repay this tax to you, ordinarily at the end of the tax year. But you don’t have to wait four months for this.

Recognising that this is an issue, there is a system in place for people to actively reclaim overpaid tax. Depending on your situation, you can complete one of three online forms to make your claim. We’ve explained these and provided links to them below.

HMRC says that this process 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
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