Pension tax 'disgrace' as £1bn overpaid by people withdrawing lump sum - how to claim refund

People withdrawing a lump sum from their pension early are being penalised by the taxman, with savers wrongly charged more than £1 billion.

The "absolute disgrace" sees those accessing their pension pots charged thousands of pounds in tax, which they then have to reclaim from HMRC. The average paid out over the first three months of 2023 was just over £3,000 per person.

The paperwork headache is due to changes in the pension system which allows those over 55-years-old to withdraw some or all of their contributions.

This has been the case since 2015, but HMRC has not acted to stop the penalty which sees some charged tax at the emergency rate, meaning they could pay thousands of pounds more than they actually owe.

Sir Steve Webb, a former pensions minister and now a partner at consultants LCP, said: "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."

Under pension freedom rules, savers are allowed to withdraw the first 25 percent of their pension tax-free. But anything more than this will be liable for tax.

If you're making a withdrawal over 25 percent for the first time, the emergency tax code will be applied which could be higher than what you should be charged. Pension tax is applied as if the person will be withdrawing the same amount from their pot every month, rather than just a one-off withdrawal.

That means people will often pay more than they should.

They then must go through the process of filing one of three forms to HMRC to be refunded within 30 days. But it's not automatic, meaning those who don't fill in the paperwork must wait until the end of the tax year to get their money back.

After another £160 million was repaid by HMRC last year, the total overpayments since 2015 now stand at £1.1bn.

More than £48m has been repaid to 15,856 people in the first three months of 2023. That means the average person was owed £3,027.

An HMRC spokesperson said: "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."

How to claim a refund on pension tax

If you've accessed your pension contributions before retirement age and think you've been charged too much tax, there are a few things you can do.

Firstly you can fill one of three HMRC claim forms, depending on your circumstances:

Forms are available on the Government website.

Secondly, you can wait until the end of the tax year when HMRC will calculate your tax refund automatically.

How to avoid pension tax overpayment

To avoid paying the large tax sum in the first place, you could take a small amount out first to get your tax code sorted before a big withdrawal.

This is because the emergency rate is applied to the first withdrawal you make over the tax-free 25% threshold. HMRC will then correct the code and your next withdrawal will be taxed at the correct rate. You'll still have paid emergency tax on the small withdrawal but this won't be anywhere near as much as you'd have paid if you took out thousands of pounds. The minimum withdrawal you can make is usually £100, but may depend on your provider. It's not clear how long it takes for HMRC to issue your pension provider with your correct code.

Andrew Tully, technical director at pensions firm Canada Life told BBC News: "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."

Remember, the first 25% of your pension savings can be withdrawn tax-free. Tax is then collected in relation to the tax band you will be in when adding your income and pension withdrawal together.

Another way to minimise disruption is to fill in the refund form at the same time as you withdraw the money, so you get your refund as quickly as possible. However, this still means you will initially be out of pocket by potentially thousands of pounds for a short period of time.

Alternatively you could make your withdrawal near the end of the tax year when HMRC calculates the refund automatically without the need to fill in a form.

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