In the last quarter of 2021, HMRC repaid £42million to pensioners that were overcharged using the Pension Freedoms rules.
How does the Pension Freedoms system work?
In 2015, Pension Freedoms were introduced to give pensioners the flexibility to use their pension money more freely. With a defined contribution pension, over 55s are able to take out up to 25% of their pension pot as one lump sum, tax free. The rest of their pension is then taxed at their normal rate of income tax.
Why have people been overcharged tax on these pension payments?
Between September and December 2021, 13,000 applied to have their overcharged pension tax bill refunded to them. The average bill issued was £3,230 and involves expats living outside UK in the same way. That’s a substantial sum, whatever financial position you’re in. These are pensioners who didn’t go over the 25% tax free lump sum amount, but still had tax taken out.
Why does this overcharging happen?
The pension providers pay HMRC the income tax due automatically, before sending any lump sum to their customers. People’s first lump sum payments are often heavily taxed because the pension provider doesn’t have your correct tax code and, therefore, applies emergency tax to the payments.
This emergency tax code is known as on a ‘Month 1’ basis. This works on the assumption that you’ll be getting that same lump sum amount every month and taxing you as if that’s your annual income. So instead of seeing it as a one off payment, it multiplies it by 12 and calculates the corresponding tax bill. Even if the total doesn’t go over the 25% tax free amount.
What to do if you think you have paid too much pension tax
You can either wait for the end of the tax year, when HMRC reconcile their books and automatically repay any tax overpayments they find. Or you can reclaim the overpayment using one of three forms:
- P55: If you’re not taking regular payments or your whole pension pot.
- P53Z: If you’ve withdrawn the whole amount of your pension and have other taxable income streams.
- P50Z: If you’ve taken your entire pension pot and you don’t have any other sources of taxable income.
What does HMRC say about this situation?
An HMRC spokesperson said: “Nobody will overpay tax as a result of taking advantage of pension flexibility. Individuals can claim back any overpayment due to an emergency tax code being applied immediately and we will repay this in 30 days.
“Anyone who does not claim will be automatically repaid at the end of the year.”
Which is great news as no one loses out indefinitely.
But some people think this is a kink in the system that HMRC should be fixing. Steve Webb, former Pensions Minister and LCP partner, said: “It is a disgrace that ordinary savers who want to access their pension savings flexibly are routinely overtaxed and then forced to claim back this excess tax. HMRC’s approach is to tax first and ask questions later. This ‘money merry-go-round’ where people have large amounts of tax deducted and then have to claim back some of it has gone on long enough.
The system is run purely for the administrative convenience of HMRC rather than the benefit of taxpayers. It would be much fairer simply to deduct basic rate tax from pension withdrawals and then adjust the amounts paid if this did not give the right answer, rather than overtaxing thousands of people every month”.
It would save thousands of pensioners a lot of time if HMRC can remove the additional admin of making a claim for the overcharging. But it’s a relief to know that this is automatically paid back to pensioners, if they’re unable to submit a claim themselves.
