Pension tax refunds: how to get your money back if you have been overcharged

HMRC returned £44 million in pension tax overpayments in the first quarter of the year, with over 15,000 retirees being issued a refund. The average repayment came to £2,881, based on figures published by the taxman.

It means over £1.4 billion has now been paid out in tax refunds since pension freedoms were introduced in April 2015, according to analysis of HMRC data by AJ Bell.

This might leave you wondering why HMRC is deducting too much tax – and whether you have been overcharged.

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The risk presents itself when you first access your pension pot. HMRC taxes your first withdrawal on a "month 1” basis, meaning it assumes you will withdraw the same amount every month for the rest of the tax year.

In reality, some savers might withdraw a large amount in one go, and then nothing in the months that follow. In cases like this, an emergency tax code might be applied, resulting in a significant tax overpayment.

How much tax could you be charged?

Imagine you withdrew £40,000 from your pension. How much tax could you be charged?

If you took the money through an Uncrystallised Funds Pension Lump Sum (UFPLS) arrangement, £10,000 would be tax-free and the remaining £30,000 would be subject to income tax. This is because you are entitled to take up to 25% of your pension pot as tax-free cash.

“If this were treated on an emergency tax basis, this would come to £11,879 in tax,” said Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.

“This is because when you are taxed on an emergency basis, you are treated as though the same amount will be taken on a monthly basis. HMRC doesn’t take account of the fact that this payment is a one off.”

“As a result, the income tax payment is calculated using 1/12th of your personal allowance, 1/12th of your basic-rate tax allowance and 1/12th of your higher-rate allowance. The remainder will be taxed at additional tax rates,” she adds.

HMRC reforms should reduce overtaxation – but you could still be hit

The good news is that HMRC has updated its system from April this year to move savers onto the correct tax code more quickly.

Consultancy Lane Clark & Peacock (LCP) said the change should drastically reduce the need for year-end reconciliations or form-filling to claim back overpaid tax, particularly where people make multiple withdrawals in a single year.

“The tax system is complex enough as it is, and this change should hopefully reduce the complications which pension savers face when they try to access their hard-earned cash,” added former pensions minister Steve Webb, now a partner at LCP.

Despite this, limitations mean the changes will only improve things for those taking a regular income. Those who make a one-off withdrawal will continue to be overtaxed. Tom Selby, director of public policy at AJ Bell, calls this “unacceptable”.

“We have only just blown out the candles on the cake celebrating 10 years of pension freedoms,” Selby said. “It is simply unacceptable that after all this time, the government has still not managed to adapt the tax system to cope with the fact Brits are able to access their pensions flexibly from age 55.”

One way savers can avoid a shock tax bill is by making a very small withdrawal first. HMRC should then apply the correct tax code to any subsequent larger withdrawals.

How to claim a pension tax refund

If you are taking a regular stream of income through pension drawdown, you shouldn’t need to do anything, according to AJ Bell. HMRC should adjust your tax code throughout the year to ensure you have paid the correct amount of tax overall.

If you make a one-off, ad hoc withdrawal, you can submit a form to reclaim the overpaid tax. This is usually refunded within 30 days. You will need to select one of three forms:

• P55: Choose this one if you have only accessed part of your pension pot.
• P53Z: Choose this one if you have emptied your pension pot, and are still working or receiving benefits.
• P50Z: Choose this one if you have emptied your pot, but are no longer working or receiving benefits.

These forms can be found on the government website.

Otherwise, you can wait for HMRC to set things right at the end of the tax year, when they should automatically refund you any overpayment. It is always worth double-checking this has been done correctly rather than just relying on the taxman.