If you’re over the age of 55 and dipped into your pension for the first time last year, then there’s a decent chance that you were significantly overtaxed.
Figures from HM Revenue & Customs (HMRC) last year revealed that a massive £61.3 million was repaid by the taxman in the third quarter of 2023 to those who have been overtaxed on pension withdrawals.
That’s up by £5 million on the previous quarter and almost double the figure from the same quarter the year before.
Some individual pension savers have been taxed almost unbelievable amounts too, according to new data from a Freedom of Information request from Royal London
It discovered that in the 2022-23 tax year around 9,700 pension savers claimed back upwards of £5,000, 2,300 claimed back more than £10,000 and 300 reclaimed more than £15,000.
For the 100 savers reclaiming the largest sums, the average was an astonishing £54,185.
That’s an incredible amount of money that these savers had to do without, simply because HMRC didn’t get the taxation right.
This is bad enough at the best of times, but given the pressures so many of us are facing on dealing with rising outgoings, the reality is that most of us can’t afford to overpay in this way, even if we will eventually get the cash back.
So why are so many savers being walloped with these excessive tax rates, and having to claim the money back?
The system doesn’t work
This all comes down to HMRC’s PAYE system, rather than anything that actual pensioners have done wrong, according to Jon Greer, head of retirement policy at Quilter.
If you have previously made withdrawals from your pension, then your pension provider will likely have the correct tax code for you.
As a result, if you make a large withdrawal from your pot, then you will be taxed properly.
The problem tends to arise when you make your first withdrawal though. If you take out a juicy lump sum from your pot for the first time, then the HMRC system may kick in, effectively expecting this to be your typical monthly income for the rest of the tax year.
In essence, HMRC views this as ‘Month 1’ of your new income setup, rather than a one-off payment.
And this is when the ‘emergency’ tax rate kicks in, meaning you end up paying a much higher bill than you really should do, leaving it down to you to then claim that overpayment back later on.
Hargreaves Lansdown has an excellent ‘emergency tax calculator’ which is well worth a look, as it can give you an indication of just how much emergency tax you are likely to have to pay on a withdrawal.
The trick to avoid a shock bill
This system for Income Tax has been in force for a while, but the ‘Month 1’ problem has been highlighted by the new pension freedoms.
Since April 2015 these have given those aged 55 or over the freedom to access their pension savings whenever they want, which the tax system isn’t really set up for.
But there is a way around this tax nightmare.
Chris Dando from Burfield Financial Planning says he’s advising his clients to take a small payment first and wait for the tax code to adjust before taking another one.
He told the Telegraph: “We are advising people to take a nominal payment. The first payment is taxed on an emergency basis as if it’s a regular payment.
So, if we take an initial £100 or even £1 then HMRC will be aware and change the tax code accordingly.
“This ensures the correct tax code is used from the first proper payment. The only downside is that it slightly delays the process, as it may be another three or four weeks before the correct code is applied to future payments.
“So people who are desperate to get their money might be better off taking the money on an emergency basis and then claiming the rest back later.”
How to reclaim tax if you’ve already overpaid
If you’ve already been caught out by this tax trap you can wait for HMRC to move you onto the correct tax code for your provider to use for future payments or claim the tax back yourself.
There are three forms for reclaiming overpaid tax as the result of a lump sum pension payment, the P55, P50Z or the P53Z.
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The P55 form is suitable for those who have made a partial withdrawal from their pension pot;
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The P50Z is for those who have taken out their entire pension as cash and have stopped working;
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The P53Z is for those who have taken their full pension pot as cash and are still receiving earned or other sources of income.
For more read our guide: Pension tax refund: how to reclaim money if you overpaid.
You’ll need a Government Gateway account to fill in the appropriate form online or you can choose to submit it by post.
HMRC will refund overpaid tax within 30 days providing the correct form is submitted. If you don’t make a claim you will eventually be refunded, though the timeline is less clear, so you could be waiting for some time.
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