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How pension freedoms overtaxing works

16 April 2018

A growing number of pension savers withdrawing cash under the pensions freedoms are being over-taxed and the start of the new tax year is the worst time fall into this trap.

As the pension freedoms celebrate their three year anniversary, savers planning to make ad-hoc pension withdrawals in the new tax year risk being overtaxed by thousands of pounds and waiting at least 12 months to get their money back.

According to AJ Bell, tens of thousands of people using the pension freedoms every month risk falling into a tax trap. The pension provider is calling upon HMRC to consult on its approach to single pension freedoms withdrawals and review the risk it poses to savers.

Who it affects 

The problem can affect anyone who takes a taxable pension freedoms payment from age 55, either through drawdown or via an Uncrystallised Funds Pension Lump Sum withdrawal.

Pension savers should be mindful that in doing so, HMRC requires pension providers to use an emergency “Month 1” tax code which means the Revenue will only provide 1/12th of the usual tax allowances available on the withdrawal. This can result in many savers being severely overtaxed.

Beware of new tax year 

The issue is most acute at the start of the new tax year. Those who make an ad-hoc withdrawal without filling out the right form to claim the money back will have to wait until at least April 2019 to get their money back.

According to official data by HMRC, around 140,000 pension pots have been accessed for the first time every quarter since the pension freedoms were introduced. The vast majority of these are likely to have been taxed on a “Month 1” basis. In contrast, only 10,500 official reclaim forms have been processed each quarter by HMRC, worth a total of £283 million.

Financial repercussions

Savers accessing their pensions for the first time will expect to receive the correct amount of money. Many people will have specific plans for their withdrawal, such as funding long-term care for a relative or paying a debt.

The following tables highlight the tax an individual would actually pay on ad-hoc pension withdrawals.

Table 1 – Tax an individual would expect to pay

Table 2 – Tax an individual actually pays
on ad hoc freedom withdrawals

Making a claim

Making a claim for overpaid tax depends on the nature of the withdrawals as well as personal circumstances. According to the Government, there are three options:

• If the payment used up the pension pot and there is no other income in the tax year, fill in form P50Z

• If the payment used up the pension pot and there is other taxable income, fill in form P53Z

• If the payment didn’t use up the pension pot and regular payments are not being taken, fill in form P55. This form is only to be used if the pension provider does not offer a refund.

Consultation and review

Arguing for the consultation and review, Tom Selby, senior analyst at AJ Bell, said: “This is not an academic problem – savers accessing their pensions for the first time using the freedoms understandably expect to receive the correct amount of money. Many will have specific plans for their withdrawal, such as to pay down debt or fund long-term care for an elderly relative. For people like this, getting thousands of pounds too little will present a serious financial challenge.

“HMRC should, at the very least, consult on its approach to single pension freedoms withdrawals and review the risks it poses to savers. Allowing providers to apply a ‘Month 12’ tax code would be a more consumer-focused solution, with HMRC taking responsibility for recouping any underpaid tax.”

 

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