HMRC overcharges £600m in pensions tax: are you owed a refund?

Hundreds and thousands of pension savers have been overcharged more than £600m in tax since the pension freedoms were introduced, according to the latest data published by HMRC.

The freedoms were implemented in April 2015 to give savers greater access to their pensions, allowing flexible withdrawals from the age of 55. Since then, more than £35bn has been withdrawn from pensions in this way by 1.4 million people.

However, those who withdraw for the first time are in danger of being charged excessive amounts of tax at an 'emergency rate', so could be entitled to a refund from the tax office.

Here, Which? explains why HMRC is overcharging pensions tax and how you can claim a refund if you've been affected.

How many people are using the pension freedoms?

Under the pension freedoms rules, savers over the age of 55 are no longer required to purchase an annuity and can withdraw from their pensions however they like. This can be done in small amounts or as a lump sum.

The number of people withdrawing flexibly has increased over the years.

Nearly 350,000 people accessed their defined contribution (DC) pension in the first quarter of this year - an increase of 23% over the same period last year.

HMRC's data shows that between January and March this year, £2.5bn was withdrawn from pensions flexibly - an increase of a fifth from the £2.1bn recorded in Q1 2019.

The chart below shows the number of individuals who have withdrawn their pension and the total value of payments since Q2 2015.

Has COVID-19 affected withdrawal rates?

The most recent data from HMRC runs to the end of March, so the coronavirus pandemic is likely to have been a factor only in the latter part of the period.

So it's not yet clear how much of a factor the economic ramifications of the virus has had on people withdrawing.

But experts warn the pandemic is likely to affect behaviour in the next quarter and beyond, with some needing to access cash to plug an income gap.

AJ Bell research suggests one in 10 people have accelerated plans to access their pension flexibly as a result of COVID-19.

• Find out more:how the pension freedoms work

Why are pensions being overtaxed?

Those wanting to access their pension pot can do so in two ways. The first is to take an uncrystallised fund pension lump sum (UFPLS). Each pension withdrawal is 25% tax-free, then the rest is charged at your normal income tax rate.

You can also take a lump sum from a pension drawdown plan. If you do this, 25% of your total pension savings are tax-free and any subsequent withdrawals are 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, many people overpay tax the first time they withdraw from their pension. This is because your provider may not know what your tax code is, or details of your other income if you have any.

If your provider doesn't have this information, withdrawals are taxed using a higher-rate emergency tax code, calculated on what is known as a 'Month 1' basis. This means you'll be taxed as though the lump sum you're withdrawing will be repeated every month.

For instance, a £10,000 withdrawal could see you being taxed as though your annual income is £120,000.

If this goes unnoticed, it can make an unnecessary dent in your overall pension pot.

• Find out more: what are my pension options?

Record year for HMRC pension tax refunds

In the past five years, HMRC has refunded £600m to freedoms users and a record £166m during the 2019-20 financial year.

Just in Q1 2020, the total amount reclaimed by savers hit nearly £33m.

More than 10,000 reclaim forms were processed in Q1 2020 and the average person received a refund of £3,141.

In Q4 2019, £32.2m was repaid by the tax office. The most HMRC has had to repay more than a quarter in Q3 2019, when it gave back more than £54m in tax refunds.

• Find out more: income drawdown calculator

How to claim back an overtaxed pension

If you've taken money out of your pension, it's important to check that you haven't paid more than you should and take action to reclaim your money.

The process is relatively straightforward and can be done online via the government's tax refund website.

If you've overpaid tax, you'll 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.

P53Z

A P53Z form should be completed if you have withdrawn all of your pension and also receive other taxable income.

P50Z

A P50Z form should be completed if you've withdrawn all of your pension, but have no other taxable income.

If you don't want to use the government's online service you can fill out a form on screen, print and post it to HMRC, or print off and fill in a form by hand.

HMRC says you should receive a refund of your overpaid tax within 30 days.

Should I withdraw my pension?

Pensions drawdown allows you to access your pension pot to provide you with a regular income. The income you get varies on your fund's investment performance and, unlike an annuity, it isn't guaranteed for life.

However, it could be suitable if you want to have more control over how your money is invested. It may also benefit you if you want the flexibility of taking out different amounts during the year and want to manage your tax liability.

However, there are other things you need to take into consideration before jumping the gun and withdrawing your money. Especially now, as the coronavirus pandemic has led to large losses in the stock market, which your pensions should be invested in.

If you want a guaranteed income for life, are concerned about running out of money or don't want to expose your pension pot to investment risk, income drawdown may not be for you.

If you do wish to withdraw, make sure you don't make any rushed decisions which could affect the longevity of your savings. It's important that you have enough to last the rest of your life.

Keep up to date on the latest coronavirus news and advice with Which?.

• Find out more: how much do I need to retire?