Pensioners are being hit with eye-watering amounts of emergency tax when they draw a retirement income - with some being overcharged by more than £50,000.
A freedom of information request by the insurer Royal London reveals the full scale of HMRC’s emergency taxing of pensioners.
There have been 9,700 incidents of pensioners being overtaxed by £5,000 or more during the 2022-23 tax year. Of those, 2,300 retirees were hit with emergency tax of more than £10,000 when they took money out of their pension pot, while 300 were overtaxed by more than £15,000.
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
The average refund per pension saver was £3,062, but the 100 biggest claimed-back sums averaged £54,185, according to the data.
Clare Moffat, pension expert at Royal London, comments: “Naturally, this could come as a huge shock to some people, especially if they had earmarked the money for something specific like a holiday or home improvements.
“Suddenly, a big chunk of the money they thought they had coming to them has in fact gone to pay emergency taxes.”
Separate data from HMRC shows that pension tax overpayment refunds are on the rise, with £61,305,602 repaid in the third quarter of last year, £5 million higher than in the second quarter.
Staggeringly, pension savers have been refunded almost £1.2 billion in overpaid tax since 2015.
Why are pensioners being overtaxed?
Pension savers are allowed to take money out of their self-invested personal pensions (Sipps) and workplace schemes as they wish from age 55, thanks to “pension freedom” rules introduced in 2015.
So, for instance, they could withdraw £100 one month, £1,000 the next month, and nothing for the rest of the year.
However, taxation of pension withdrawals is similar to taxation of any other income, with an “emergency” rate being applied where there isn’t a tax code. This means that HMRC taxes the amount withdrawn as if that will be the pension saver’s income every month for the rest of the tax year.
Take someone who took £30,000 as the first withdrawal from their Sipp. They would normally receive £7,500 as tax-free cash (25% of the withdrawal) and the remaining amount is taxed as if their monthly income is £22,500, even if the pension holder has no intention of taking further pension income that year.
According to Royal London, they would pay £8,503 in emergency tax. However, if the only withdrawal that year was the £30,000, and they received no other income, they should pay basic-rate tax of just £1,984.
This means they have been overtaxed by £6,519 and would need to claim it back.
Moffat notes: “These are not small sums and illustrate how the current system is springing an unwelcome surprise on many at a time of their lives when they can least afford it.”
Ian Cook, chartered financial planner at the wealth manager Quilter, adds: “It is particularly frustrating for those trying to access their funds quickly. Often people do not understand why this has happened given it arises due to an oddity within the PAYE system. The system needs an overhaul.”
For someone to be overcharged by £50,000, they would need to have taken out a lump sum from their pension of more than £200,000. Moffat says these are extreme cases, although some pension savers may have withdrawn a large amount possibly “to help their children or grandchildren get a foot on the housing ladder”.
How can pension savers avoid being overtaxed?
One way to avoid an emergency tax bill is to make your first withdrawal a small one. This will govern how much tax you pay on future withdrawals.
“While there may be a desire or an urgent need to make your first pension withdrawal a large one, you should be mindful that you may find yourself charged excessive tax,” says Moffat.
According to the pension provider PensionBee, you may also be able to avoid excess tax by providing an up-to-date tax code or P45 to your pension provider before the withdrawal is made.
How can pensioners claim the tax back?
If you are hit with emergency tax, you can either complete a form and wait for a refund, or submit a self-assessment tax return.
Unfortunately, as with most tax matters, filling in the form is not a straightforward task, as first you need to choose which one to complete. There are three different forms.
If you are taking only some of your pension and leaving some in the pot, you should fill out the P55 form. If you are taking the whole lot, and have no other income sources for that tax year, fill out P50Z. If you are receiving another income, complete form P53Z.
These can be completed online on gov.uk. It can take 14 days for HMRC to reply. Refunds are paid directly into the pension saver’s bank account.
Timescales to receive the money vary; Royal London says it recently heard that someone had a four-week wait to receive their money back.
It’s also possible to wait until the end of the tax year and get a refund after filing a self-assessment tax return.
How does the Lifetime ISA work? Key LISA rules
AJ Bell: a fine British fintech going cheap
