HMRC pays back £627m in overpaid pension tax: are you owed a refund?

Hundreds of thousands of pension savers have been overcharged £627m in tax since the pension freedoms were introduced in 2015, according to the latest data published by HMRC.

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

Since 2015, the total value of flexible withdrawals from pensions has now exceeded £37bn. But 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 pension 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 who have reached the age of 55 are no longer required to purchase an annuity and can withdraw from their pension in small amounts, or as a lump sum.

The number of people withdrawing flexibly has generally increased over the years; the second quarter of 2020 saw 340,000 individuals withdraw, a 1% increase from 336,000 in the same quarter of last year.

Although amid the ongoing coronavirus pandemic, there has been a decrease in the number of individuals withdrawing compared with the first quarter 2020, when 348,000 people withdrew from their pots.

The chart below shows the number of individuals who have withdrawn their pension and the total value of payments since the second quarter of 2015.

Covid-19 crisis reduces withdrawal rates

The amount of people that have been withdrawing their pension has reduced compared with last year.

Some £2.3bn was withdrawn flexibly from pensions between April and July. This figure was down 17% compared with the second quarter of 2019 when £2.8bn was withdrawn flexibly from retirement pots.

The average amount withdrawn per individual in the second quarter of 2020 was £6,700, falling by 18% from £8,200 in the second quarter of 2019.

Since reporting became mandatory in the second quarter of 2016, average withdrawals have been falling steadily and consistently, with peaks in the second quarter of each year becoming a noticeable trend. However, on this occasion there's not been a peak in the second quarter.

AJ Bell says that the drop suggests many people chose to either pause, access, or reduce their income as markets plummeted as a result of the coronavirus crisis.

• 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.

HMRC pays back £27m in overpaid tax during lockdown

HMRC has paid back £27m in overpaid pension tax to people in the second quarter, down from £32m in the first quarter, and £47m in the first quarter of 2019.

Meanwhile 7,649 pension tax reclaim forms were processed between April and June, compared with over 10,000 in the first quarter and 17,000 in the second quarter of 2019.

Nonetheless, HMRC says that the average amount reclaimed per person hit a record high of over £3,500 in the second quarter this year, which was £845 more than the same period last year.

• Find out more: what are my pension options?

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.

• Find out more: income drawdown calculator

Should I withdraw my pension?

Pension 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?