HMRC overcharges £500m in pension tax: are you owed a refund?

Hundreds of thousands of pensioners have been overcharged more than £500m in tax since the introduction of the pension freedoms in 2015, according to the latest data published by HM Revenue & Customs (HMRC).

The new pension rules were designed to give people more control of their retirement income, allowing people over the age of 55 to withdraw money from their pension pots when they wanted.

Almost £30bn has been taken out of pensions since the freedoms were introduced, but hundreds of thousands of people have accidentally triggered excessive tax charges when they did withdraw money from their pension pot. HMRC has faced criticism, with some pension experts labelling this system as 'draconian'.

Here we explain why HMRC is overcharging pension tax and how you can claim a tax refund if you think you've been affected.

How many people are using pension freedoms?

The UK pensions system was radically overhauled in the 2014 Budget, which introduced the pension freedoms in April 2015.

Under the new rules, pension savers over the age of 55 are no longer required to buy an annuity and can withdraw money from their pension pots however they like.

They could even withdraw all of their savings in one go if they wanted to.

Since 2015, more than £30bn has been withdrawn from pension pots. Between July and September of 2019 alone, £2.4bn was taken out of pension savings, a 21% increase from the same period in 2018.

However, 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). Each withdrawal is 25% tax-free, with the rest charged at your normal income tax rate.

The other way is to take a lump sum from a pension drawdown plan. The first 25% of your total 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 at 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 owed.

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

HMRC forced to repay more than £500m

HMRC has refunded more than half a billion pounds in overpaid tax from pension savings in just over four years.

More than 17,000 people had to claim back overpaid tax on pensions in the third quarter of 2019, with the average claim coming to £3,162.

A total of 221,456 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.

• Find out more: what is income drawdown?

How to claim 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 form should be used if you haven't withdrawn your entire pension pot and are not taking regular payments either. HMRC received 10,379 claims from savers in this situation in the third quarter of 2019.

P53Z

If you have withdrawn your entire pension pot and also receive other taxable income, you will need to complete a P53Z form. Around 5,253 claims of this nature were made during this period.

P50Z

The P50Z form should be used if you have drawn down your entire pension pot but have no other taxable income. This type of claim received the fewest applications, with only 1,753 sent to HMRC since July 2019.

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 income drawdown the right option 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.