HMRC overcharges more than £400m in pension tax: are you affected?

Pensioners have been overtaxed to the tune of a staggering £400m since the pension freedoms were introduced in 2015, according to the latest data published by HM Revenue & Customs (HMRC).

The pension rules introduced four years ago aimed to give people more control over their retirement income, allowing pension savers over the age of 55 to withdraw money from their pension pots whenever they like.

Since 2015, almost £23.6bn has been taken out of pensions, but hundreds of thousands of people have inadvertently triggered excessive tax charges when they do access their pension pot. The system used by HMRC to collect tax from pensions has been labelled as 'draconian' by pension experts.

Here we take a look at why HMRC is overcharging on pensions tax and what to do if you think you might be affected.

How many people are using the pension freedoms?

The April 2015 budget saw the introduction of the pension freedom rules which gave a radical shake-up to the UK's pension system.

Under the new rules, pension savers over the age of 55 were no longer required to buy an annuity and could withdraw money from their pension pots however they like. They could even withdraw all of their savings in one go if they wished.

Since 2015, more than one million people have withdrawn around £23.6bn from their pension pots. In the final six months of 2018 alone, 448,000 savers withdrew £6.13bn of retirement income.

The table below shows the number of payments taken from pensions and their value since the changes were introduced.

While the changes give pension savers more control over their retirement funds, many are at risk of being overtaxed when they make a withdrawal under the current tax system.

• Find out more: how pensions work

Why are pensions being overtaxed?

There are two main ways of withdrawing money from your pension pot. The first way is to take an 'uncrystallised fund pension lump sum' (UFPLS). With these kinds of withdrawals, 25% is paid tax-free and the remaining 75% issubject to income tax.

The other way is to take a lump sum from a pension drawdown plan. The first 25% of your pension savings are tax-free, and any subsequent withdrawals will be subject to income tax.

Your pension company collects the tax on your behalf, so the lump sum you get is paid net of tax. 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 your other income, if you have any.

So, tax is calculated on what is known as a 'Month 1' basis, meaning 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 taxed as though your annual income is £120,000.

This can often go unnoticed by savers, meaning that they lose significant sums of retirement income to tax that isn't owing.

• Find out more:what can I do with my pension pot?

HMRC forced to repay £402m

HMRC has refunded a whopping £402,743,108 in overpaid tax from pension savings in just under four years.

Around 14,000 people had to claim back overpaid tax on pensions in the last quarter of 2018, with the average claim coming to £2,161.

A total of 174,260 people have been forced to reclaim overpaid tax on their pension since 2015.

The table below shows how much HMRC has overcharged in tax on pensions and the number of claims that have been made since 2015.

The figures, however, represent the tip of the iceberg - as they only include those people who have reclaimed their money.

Former pensions minister and director of Royal London, Sir Steve Webb, told Which? that HMRC's approach is causing grave inconvenience to taxpayers.

'It is outrageous that HMRC's approach is to tax first and ask questions afterwards,' said Sir Steve.

'Since the system started in 2015, more than 170,000 people have had to fill in forms to claim back tax they should never have had to pay.

'There are ways to get around the system, such as making a small initial withdrawal which should trigger HMRC to issue a tax code which can then be applied to larger withdrawals.

'But all of this adds delay and inconvenience. The system should be run for the convenience of taxpayers, not the convenience of HMRC.'

• Find out more: what is income drawdown?

Claiming back overtaxed pension

If you're planning to make a pension withdrawal, make sure to check your tax liabilities carefully - both for the months you made the withdrawal, and the subsequent months.

If you find that you've overpaid tax on your pension, you will need to fill out one of three claims forms.

P55

A P55 formshould be used if you haven't withdrawn your entire pension pot and are not taking regular payments either. HMRC received 6,218 claims from savers in this situation in the first quarter of the year.

P53Z

If you have withdrawn your entire pension pot and also receive other taxable income you will need to complete a P53Z form. Around 3,448 claims of this nature were made in the first three months of 2018.

P50Z

The P50Z form should be used if you have drawdown your entire pension pot but have no other taxable income. This type of claim received the lowest amount of applicants with only 988 sent to HMRC since the beginning of the year.

All of the forms can be found on the government's claim a 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: income drawdown calculator - making your money last

Is pension 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.

Income drawdown may be suitable if you want to have more control over the way your money is invested. It might also be convenient if you want the flexibility of taking out different sums during the year and managing your annual tax liability.

But if you want a guaranteed level of income each year or you're if you're concerned about running out of money or don't want to expose your pension pot to investment risk, income drawdown might not be right for your needs.

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.

For more information, take a look at our guide on income drawdown and check out the short video below.