The misery of applying for pension tax refunds has been dragging on for a decade - but the end may be in sight after HMRC announced it will reform the system from April.
Thousands of retirees are overtaxed on their pension withdrawals every year, and must try to get a refund from HMRC.
A massive £1.37 billion has been reclaimed by people overtaxed on pension withdrawals since 2015.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Get 6 issues free
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
In the last three months of 2024, more than 14,600 repayment claims were processed, amounting to almost £50 million.
Critics have long called the situation a “tax nightmare” and a “scandal” while pointing out that a shock tax bill is not a nice way to start retirement.
But now HMRC says it wants to improve the system by quickly taking retirees off emergency tax codes and making sure they aren’t overtaxed.
Sir Steve Webb, partner at pension consultants LCP and a former pensions minister, said reforming the “scandalous system” feels like a big breakthrough after complaining about it for years.
“For too long, hundreds of thousands of people have been overtaxed and had to jump through hoops to claim back their own money. This new system should mean that far more people are quickly moved on to the correct tax code and no longer end up with an overpayment of tax,” he commented.
Why do pension withdrawals get overtaxed?
The overtaxation typically happens when a retiree accesses their pension for the first time and pays an emergency rate of tax.
Pension savers are allowed to take money out of their self-invested personal pensions (Sipps) and workplace schemes as they wish from age 55 (rising to 57 in 2028). So, for example, they could withdraw £500 one month, £2,000 the next month, and nothing for the rest of the year.
Pension withdrawals are subject to income tax, bar the 25% tax-free cash. HMRC taxes the first flexible withdrawal someone makes in a tax year on a “Month 1” basis. This means the withdrawal is taxed as if that will be the retiree’s income every month for the rest of the tax year.
That can lead to far too much tax being taken off the pension payments.
The latest HMRC figures reveal that people are claiming back an average tax refund of £3,390.
Tom Selby, director of public policy at AJ Bell, notes: “This is likely only the tip of the iceberg, however, as it only captures those who fill in the relevant HMRC reclaim form. In reality lots of people, such as those on lower incomes who are less familiar with the self-assessment system, will not go through the official process of reclaiming the money they are owed.”
What has HMRC announced?
Tucked away in a routine newsletter to pension schemes, HMRC said that from April 2025, it will improve “how tax code information is used for those people who are new to receiving a private pension, so they pay the right amount of tax from the outset”.
It goes on: “We will automatically update the tax code for customers who are on a temporary tax code and would benefit from being on a cumulative code - this means they’ll avoid an overpayment or underpayment at the end of the year. There is no need to contact HMRC and once a tax code has been changed we’ll inform customers by letter or digitally if they’ve signed up for paperless in the HMRC app or online."
Webb says the change “should hopefully reduce the complications which pension savers face when they try to access their hard-earned cash”.
He adds that the reform will “drastically reduce the need either for end-year reconciliations or form-filling to claim back over-paid tax, particularly where people make multiple withdrawals in a single year”.
However, Selby warns that the reforms don’t go far enough, as they won’t help “those people taking ad-hoc lump sums from their drawdown pot and still means the first payment for all will be overtaxed”.
Jon Greer, head of retirement policy at the wealth manager Quilter, calls the planned reforms “promising”, but adds that “it remains to be seen whether they will fully address the complexities and inefficiencies of the current system”.
How can pensioners claim a tax refund?
If you are taking a steady stream of income via drawdown then you shouldn’t need to take any action, as HMRC will adjust your tax code to ensure that over the course of the year you are taxed the correct amount.
However, if you are hit with emergency tax due to a single withdrawal or ad-hoc withdrawals, you can either complete a form and apply for a refund, or wait for HMRC to put you in the correct position at the end of the tax year.
Which form you need to fill out will depend on how you have accessed your retirement pot:
- If you’ve emptied your pot by flexibly accessing your pension and are still working or receiving benefits, you should fill out form P53Z
- If you’ve emptied your pot by flexibly accessing your pension and aren’t working or receiving benefits, you should fill out form P50Z
- If you’ve only flexibly accessed part of your pension pot then use form P55
Refunds are usually paid within 30 days and are sent directly to your bank account.
Zoopla: House prices slows to 1.4% in May as rate of sales at four year high
FCA reveals 'once in a generation' advice changes - what the reforms mean for you
