Pension savers slapped with £1BILLION in emergency tax on withdrawals

The amount of ’emergency tax’ reclaimed by people making withdrawals from retirement pots has topped £1billion.

Since pension freedom reforms were introduced in 2015, HMRC slaps extra tax on any initial sum taken from a fund on the assumption it could be ‘month one’ of a series over the rest of a tax year.

In a system dubbed an ‘absolute disgrace’ and ‘a scandal’ by critics, pension savers then have to claim back their cash from the taxman themselves or wait until it’s sorted out after the end of the current tax year.

Pension savers slapped with £1bn to date in emergency tax on withdrawals – which they then have to claim back or wait for taxman to sort out the following year

New figures announced by HMRC today show that reclaimed overpayments hit £48.5million in the first three months of 2023.

That is up from £22million at the same time last year, as more people tap their pensions to make ends meet as household bills soar – and the total reclaimed since 2015 now stands at £1.02billion.

> How to reclaim YOUR pension cash: Find out below

The news from the Government that tax refunds have now surpassed £1billion prompted a renewed outcry from pension experts who believe this is an unfair burden on savers.

Former Pensions Minister Steve Webb says: ‘This is an absolute disgrace. A system based on systematic over-taxing of pension savers cannot be right.

‘There is no good reason why citizens who access their pension should have to go through the hassle of claiming back excess taxation which they should never have had to pay in the first place. 

‘And we are not talking about small sums, with over £1billion being paid back by HMRC so far.’

Webb, a partner at LCP who is also This is Money’s pensions columnist, says: ‘Reform of the system is long overdue so that it works to the benefit of pension savers and not the Treasury.’

Tom Selby, head of retirement policy at AJ Bell, says the figure is ‘astonishing’, adding: ‘It is a scandal that the Government has failed to adapt the tax system to cope with the fact Brits are able to access their pensions flexibly from age 55.’

He accused the Government of ‘persisting with an arcane approach which hits people with an unfair tax bill’, requiring them to fill in one of three forms if they want to get their money back as soon as possible.

‘People on lower incomes who are less familiar with the self-assessment process might be less likely to go through the official process of reclaiming the money they are owed. As a result, they will be reliant on HMRC putting their affairs in order.’

Andrew Tully, technical director at Canada Life, says: ‘Eight years on from the introduction of the pension freedoms there must be a better way to administer the tax position around flexible pension withdrawals which would mean HMRC is not processing refunds to the tune of £1bn.

‘A good tip for those customers making a pension withdrawal for the first time, is to initiate a small withdrawal of say £100.

‘That will generate a tax code from HMRC which the pension provider will apply to any subsequent withdrawals. 

‘That will result in the tax being taken at source being far more accurate in many more cases, not only reducing the burden of paperwork but equally importantly the customer receiving a more accurate withdrawal in the first place.’

Jon Greer, head of retirement policy at Quilter, says of the refund figures for early this year: ‘This huge increase in the number of claim forms processed demonstrates the continued necessity for people to access their pension funds amidst the intensifying cost-of-living crisis impacting day-to-day financial situations.

‘Unfortunately, this system leads to prolonged waiting periods for people to receive their full expected amount at a time when they need it more than ever.’

‘This system clearly needs a rethink as these ever increasing figures do not point to a process that is working well.’

An HMRC spokesperson says: ‘Nobody overpays tax as a result of taking advantage of pension flexibility.

‘We will automatically repay anyone who pays too much because they’re on an emergency tax code. Individuals can claim back any overpayment earlier if they wish.’

If you do not apply directly to HMRC for a refund, it will work out your annual bill at the end of the tax year as part of the usual reconciliation exercise. 

What is the ’emergency tax’ pension trap – and how do you get your money back?

When you make an initial withdrawal from a defined contribution pension pot, HMRC assumes it will be the first of many over the rest of that tax year, which could push you into a higher tax band than normal.

It therefore applies an emergency tax rate on the basis that this could be only the first in a run of withdrawals.

Retirees get caught out if they make a large first withdrawal as a one-off, or if they intend to take smaller regular or ad-hoc amounts thereafter.

The tax deducted might be particularly onerous if you make a withdrawal in April, at the start of a new tax year, and don’t plan any further ones.

To get a tax overpayment back as soon as possible, you can do so using one of the following three forms

P50Z – if the payment used up your pension pot and you have no other income in the tax year

P53Z – if the payment used up your pension pot and you have other taxable income

P55 – if you have withdrawn only part of your pot and you’re not taking regular payments.

If you don’t proactively claim, you should get a refund via your tax return after the end of the current tax year, though this can be a long time to wait.

Pension experts suggest making smaller withdrawals and spreading them out, so you are taxed correctly at the start of retirement rather than having to claw overpayments back later.

> Read our guide to emergency tax on pension withdrawals

This post first appeared on Dailymail.co.uk