Reclaim overpaid pension tax

Reclaim overpaid pension tax

Some pensioners could be due £1,000s or even £10,000s back

Have you taken some taxable money from your pension for the first time? If so, you could be one of thousands of people due back £1,000s or even £10,000s in overpaid tax. And while you'll be automatically refunded any extra tax you've paid by the end of the tax year, it still leaves you temporarily out of pocket – in some cases by up to 12 months. This guide talks you through whether you've overpaid and, if so, how to get your money back sooner.

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Why are people being overcharged pension tax?

It used to be that you had to buy something called an 'annuity' – a product paying you an income each year until you die – if you wanted to access the money in your pension(s).

But since new pension rules coined 'pension freedoms' were introduced in April 2015, you no longer have to opt for an annuity. You can instead, for example, withdraw money from your pension in small amounts as and when you like, or even as a lump sum.

While this has meant much more flexibility for pensioners, this newfound freedom has thrown up a tax issue for people accessing any taxable cash from their pension pot for the first time.

Many have been charged the much-inflated emergency tax on their first taxable withdrawal, instead of the normal tax they should have paid. 

This tax error has seen HM Revenue & Customs pay back £925 million in overpaid pension tax to date (since the rule change).

In fact, data from HMRC shows that in Q3 of 2022 alone, almost 10,000 forms to reclaim overpaid pension tax were filled in by savers in total, with £33 million repaid, and the average amount reclaimed being £3,324.

Here's how it works...

You may have already accessed your 25% tax-free cash – that won't be affected by this issue as it's simply not taxable. But when you take taxable cash out of your pension pot for the first time in theory you should only have to pay your normal income tax. 

But if HMRC has not given the pension provider a tax code (which is very likely), then the provider has to deduct income tax using an emergency tax code.

An emergency tax code is a temporary tax code used where no tax code has been issued by HMRC. It applies a 'month one' approach to the taxation of withdrawn pension funds, which essentially means HMRC assumes you will make the same withdrawal every month for the next 12 months and not just the one you have made. 

For example, if you decide to withdraw £10,000 in April, HMRC then wrongly assumes you will make the same withdrawal in May, June, July, August, September, October, November, December, January, February and March.

This could mean you'll end up paying £1,000s, or even £10,000s, in extra tax – which could be a massive issue for anyone accessing a lump sum for something specific, for example, giving it to a child for a house deposit or paying off the remainder of their own mortgage.

Have I been affected?

You may have been affected by this and could be due a refund from HMRC if you are over 55 (the age you're allowed to access your pension pot from) and have: 

  • Taken a taxable lump sum from your pension for the first time, OR 
  • Withdrawn your whole pension pot at once.

Before reading further, there are TWO KEY THINGS to understand: 

  • If you have been overcharged, you will get the money you're due back automatically BUT not until the end of the tax year which finishes on 5 April (either directly into your bank account or as a cheque). This could be nearly 12 months later if you made the withdrawal at the start of the tax year – the tax year ends on 5 April so if you made the withdrawal on 6 April you will have to wait 365 days until you get your money back. It might, however, be less of an issue if you made the withdrawal at the end of the tax year. 

  • This ONLY affects people withdrawing a taxable sum for the first time and NOT anyone accessing their 25% tax-free cash (you can take a quarter of your pension pot free of any tax) as the tax-free status simply means this is not an issue. You will also not be overcharged for any subsequent taxable withdrawals as you will then have your correct tax code. However, if for whatever reason you have not consolidated all your pension pots into one large pot before accessing your cash, this could become an issue if withdrawing from a different pension provider.

This guide takes you through how much you could be due back and how you can reclaim your money as soon as possible. For more on how you can withdraw your pension, see Martin's pension briefing

What you should be paying in tax vs what you end up paying without the correct tax code

Right, this is the techie part, but we will take you through it step by step. If you were on the correct tax code you should simply be charged tax like you normally would if you received a salary each month as follows:

  • Personal allowance – this means you pay no tax on up to £12,570 (you get a new personal allowance every tax year)
  • Basic-rate 20% tax – paid on earnings between £12,571 and £50,270
  • Higher-rate 40% tax – paid on £50,270 – £150,000
  • Additional-rate 45% tax – paid on £150,000+

Here's an example of someone withdrawing £20,000 (assuming no other income that tax year)...

SCENARIO 1: WHEN THEY GET IT RIGHT – how you should be taxed

  • You'll be charged no tax on £12,570 (which is your personal allowance)
  • You'll be charged 20% tax on £7,430 (£20,000 – £12,570) which is £1,486
  • Total tax charge: £1,486

SCENARIO 2: WHEN THEY GET IT WRONG – how you could end up being taxed

Don't worry: you won't be asked to calculate this yourself – it's very technical – and you can skip this section if you like. We've outlined the maths below so you can see how it works, and it's only if you want to know the ins and outs.

If you'd like to know how much you're due back, then use the Government's calculator.

A £20,000 withdrawal would tax you as though your annual income is £240,000 (£20,000 x 12), so:

  • As HMRC (wrongly) assumes this is the first of 12 withdrawals, it only allows you 1/12th of the personal allowance on the £20,000 withdrawal. This means you'll pay no tax on just £1,048 (1/12 of £12,570).

  • You'll be charged tax on the remaining £18,952 (£20,000 – £1,048 = £18,952). And this is how that tax is calculated:

    – HMRC divides the £37,700 basic-rate 20% band by 12, which is £3,141. This £3,141 is taxed at the 20% basic rate, which equates to £628 in tax.

    – It then divides £112,300, which is the difference between the top and bottom of the higher-rate 40% band (the technical details of this are mind-boggling!), by 12. This gives £9,358. This £9,358 is taxed at the 40% higher rate, which equates to £3,743 in tax.

    – The rest of the withdrawal (£6,451, which is £18,952 – £3,141 – £9,358) is then taxed at the 45% additional rate, which equates to £2,904 in tax.
  • Total tax charge: If we add together the total charge in each band (£628 + £3,743 + £2,904) that means there's £7,275 tax to pay – £5,789 more than you should actually pay.

The table below demonstrates how much tax you should be paying and how much you could end up paying if an emergency tax code is applied on different amounts.

It assumes you have already taken your 25% tax-free allowance, meaning that anything withdrawn after this will be taxed at your marginal tax rate.

How you could be WRONGLY TAXED

Amount withdrawn Taxed right Taxed wrong
£2,000 £0 £190
£5,000 £0 £952
£10,000 £0 £2,952
£20,000 £1,486 £7,275
£50,000 £7,484 £20,775

Table uses different withdrawal amounts - assuming no other income.

Source: Pension platform AJ Bell.

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How do I claim the tax back?

Annoyingly there is nothing you can do to stop HM Revenue & Customs (HMRC) charging you too much tax in the first place if your pension provider does not have the correct tax code. But thankfully you can apply for the money back immediately and HMRC will return it within 30 days of you making the request.

Importantly, even if you do nothing, HMRC says it will automatically get the overpaid tax back to you by the end of the tax year (for this year that's April 2022).

However, keep in mind that if you made a withdrawal on 8 April for example – at the beginning of the tax year – you could end up having to wait almost a whole year to get your money back. 

There are three forms – which one you need to fill in depends on your circumstances 

To get your money back before the new tax year, you'll have to fill in one of three different forms. Your personal circumstances and what sort of withdrawal you've made will determine which form you need to fill in: 

  • Emptied your pension and have no other income in that tax year? Use: P50Z
  • Emptied your pension but have other taxable income that tax year? Use: P53Z
  • Haven't emptied your pension pot? Use: P55

In the forms you'll be asked how much you withdrew and how much tax you got charged, but not how much you expect to get back – this is calculated for you. 

You can fill the form in online using a Government Gateway login, or you can print and fill in the form and send it in the post – all postage details are on the form. If you can't access the form online, get in touch with HMRC on 0300 200 3300, to see how it can help.

Get the money back within 30 days

Once you've sent the form you'll get the money back within 30 days.

  • The money will be paid directly to your bank account if you provided your account details on the form. 
  • If the money is coming back to you at the end of the tax year and HMRC has your account details, it will be paid into your account – if not, you will be sent a cheque.

Important: You're NOT paid any interest on the money when it comes back to you – another reason why it's best to apply as soon as possible rather than waiting to be paid automatically at the end of the tax year, when the money may have been out of your account for a lot longer.

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Thinking of drawing some money from your pension? Here's how to minimise this issue

As we've explained in this guide, unfortunately you can't avoid being charged the incorrect amount of tax. However, there are a few things you can try to avoid being hit so hard and to speed up the process.

  • Fill in the form to get your overpaid tax back AT THE SAME TIME you make the withdrawal. If you fill in the form straightaway, there won't be too much of a time lag between being taxed and getting the money back.

    This is crucial if you're using the money for something important – such as for a child's house deposit – where securing the property depends on having the exact amount you need and falling short could see the sale fall through. You could even fill in the form on the same day you make the withdrawal to really speed up the process. 

  • Make a small taxable withdrawal before you make the 'real' withdrawal to minimise the tax being overcharged. As this problem only occurs the first time you withdraw a taxable sum of money from your pension (basically the first time you withdraw anything that isn't your tax-free lump sum), you could withdraw the minimum amount allowed by your pension provider BEFORE you make your real and bigger withdrawal. The smallest amount you can withdraw could be anything from £100, but check with your provider to see what it allows and also check there isn't a big charge for withdrawing money from your pension which would outweigh this approach. 

    Although this nominal withdrawal would still be taxed using an emergency code, it then triggers the issuing of a correct tax code and this can be used for any later withdrawals for the amount you actually wanted to take out.

    How long it takes to change a tax code would depend on individual circumstances, according to HM Revenue & Customs (HMRC), but hopefully it can be done quickly. You can check in with HMRC or your pension provider to make sure it's all sorted. 

  • Make your withdrawal closer to the end of the tax year. If you're not under any time pressure of when you need to make a withdrawal, you could be tactical and take out the money closer to the end of the tax year. For example, if you take the money out right at the beginning of April, you would get anything owed a few days later – the end of the tax year. 

Is HMRC doing anything to fix this?

In short, no. We asked HMRC if it's doing anything to address this issue.

An HMRC spokesperson said: "Following the introduction of pension freedom in flexible pension payments in 2015, HMRC introduced a rapid refund process to enable those who had paid too much tax to reclaim and receive payment within 30 days.

"While HMRC keeps all areas of tax administration under review, there are currently no plans to change this process."

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