Hundreds of thousands of savers have overpaid tax on their retirement savings by more than £330m since the introduction of the pension freedoms in 2015, according to new data published by HM Revenue & Customs (HMRC).
In the second quarter of 2018, HMRC repaid £28m to people who had too much income tax taken from their pension savings, taking the total for the year to £51m
Around 140,000 people have so far had to actively reclaim tax on pensions but many more could be owed money.
The tax was incorrectly applied to people withdrawing money from their pension pots under the new pension freedoms.
Find out why so many people are being overtaxed on their pensions and how to reclaim money if you’ve been affected.
Why are pensions being overtaxed?
The new pension freedom rules allow savers over the age of 55 to withdraw money from their pension pots whenever they like. This means that you could take out all of your savings in one go if you wanted to.
There are two main ways of withdrawing money from your pension pot. The first is to take an ‘uncrystallised fund pension lump sum’ (UFPLS). With this type of withdrawal, 25% is paid tax-free and the remaining 75% is subject to income tax.
The alternative way is to take a lump sum from flexi-access drawdown. With this type of withdrawal, the first 25% of your pension savings is tax-free and any subsequent withdrawals will be subject to income tax.
When you get a payment from your pension, pension companies collect the tax on your behalf, through the Pay As You Earn system. However, when you make your first withdrawal, you’re likely to be taxed on an ‘emergency rate.’
This is because your pension company doesn’t know what your tax code is or details of any other income you may have.
In this scenario, tax is calculated on a ‘Month 1’ basis, which means you’ll be taxed as though the lump sum you’re drawing will be repeated every month. A £10,000 withdrawal could see you end up being as though your annual income is £120,000.
We explain more about this works and how to avoid a huge tax bill in our story.
Pensions tax overpayments can often go unnoticed by savers meaning that savers lose large amounts of retirement income to tax that that wasn’t owed.
- Find out more: what the pension freedoms mean for you
Average pension tax refund now £2,000
The pension freedoms were introduced in 2015 and since it’s launch, HMRC has refunded over £330m in overpaid tax from pension savings.
More than 14,000 people have claimed back overpaid tax on pensions in the second quarter of 2018, with average claim coming in at £2,003.
The total number of people who’ve been forced to reclaim overpaid tax on pensions now stands at 141,915.
HMRC’s system for collecting tax in this way has been labelled as ‘draconian’, the government has refused to make any changes to the way it taxes pension drawdown.
In a recent announcement, it stated that any changes to the current system ‘would not significantly improve the tax position for the majority of recipients of flexible drawdown.’
The government also maintained that the emergency pensions tax system ‘remains the most effective method of deducting tax in these cases and it reduced the risk of underpayments of tax arising.’
Policy director at Royal London and former pensions minister, Sir Steve Webb, stressed the need for the current system of tax to be simplified.
‘HMRC’s stubborn refusal to change the way it taxes pension withdrawals shows that it puts the convenience of the tax office ahead of the convenience of the public.
‘A simpler system would deduct basic rate tax at source and leave high rate taxpayers to pick up the balance where appropriate through their tax return. Until the system changes, taxpayers will find it almost impossible to understand how much tax has been or will be withdrawn from their pension payments’ he said.
- Find out more: should I take a lump sum from my pension pot?
What to do if your pension is overtaxed
If you’d like to make a pension withdrawal, be sure to check your tax liabilities carefully – both for the months you make the withdrawal and subsequent months.
You’ll have to complete one of the following three forms if you find that you’ve overpaid tax on your pension.
A P55 form should be used if you haven’t withdrawn your entire pension pot and are not taking regular payments either. HMRC received 9,558 of these claims in the second quarter of the year.
You will need to complete the P53Z form if you have withdrawn your entire pension pot and also receive other taxable income. Over the last three months 3,614 types of these claims were made.
The P50Z form should be used if you have withdrawn your entire pension pot but have no other taxable income. During Q2 of 2018 1,305 of this type of clam were made.
Each claim form can be found on the government’s claim tax refund page.
In some cases, HMRC will post you a P800 which includes your tax calculation for the year and identifies where you might have overpaid on pension income.
- Find out more: what is income drawdown?
Is income drawdown right for you?
The new pension freedoms offer savers more flexibility and control over how their retirement income is managed. But before you start dipping into your pot, there are some considerations to bear in mind.
Pension drawdown offers more control over the way your retirement savings are managed. They remain invested in the stock market, meaning they could grow further, and provide the flexibility of taking out different sums during the year and managing your annual tax liability.
The other side of this coin is that your pension is still exposed to investment risk, and could fall in value at a time when you are no longer working and cannot rebuild your savings.
Income drawdown is not be the best option if you want a guaranteed level of income each year.
Your retirement savings need to last you a lifetime – so before you make a decision, ensure you fully understand the consequences and seek qualified financial advice.