Over-55 pension savers overtaxed by £400 million - here's how to avoid being stung

Published by Tom Bailey on 31 January 2019.
Last updated on 31 January 2019

HMRC

The number of pension savers being hit with a tax bill on pension lump sum withdrawals has continued to grow.

Pension savers have been overtaxed by £400 million since pension freedoms were introduced in April 2015, new figures released by HM Revenue & Customs (HMRC) show.

The problem arises when individuals over the age of 55 make lump sum withdrawals from their pension. Under the pension freedoms the first 25% taken is tax-free, but the remaining 75% subject to income tax at an individual’s marginal rate.   

However, a lack of information and to up-to-date tax codes leads HMRC to apply an 'emergency' tax code, which results in tens of thousands of pension savers being overtaxed each year.

While savers owed tax are repaid, as Moira O’Neill, head of personal finance at interactive investor (Moneywise's parent company), notes: “Repayments can take a long time and the process can be a huge inconvenience.”

HMRC has had to pay back tax on around 174,000 occasions since 2015, totalling £402 million in repayments. In the fourth quarter of 2018 alone, figures show over £30m was repaid to over 13,000 people.

The scale of these figures, says Helen Morrissey, pensions specialist at Royal London, underlines the need for HMRC to reform the way it handles tax free lump sums.

She says: "HMRC is utterly shameless in the way that it over-taxes people and then expects them to claim a refund.

“The system should be run for the convenience of taxpayers, not the convenience of HMRC.  It is time that this over-taxing spree was brought to an end.”

Preempt emergency tax

Ms O’Neill offers the following advice for savers: “It’s worth planning well ahead when getting ready to start taking pension income - think about requesting only a nominal payment in order to trigger a new tax code."

Your tax code will then be set at the level of the initial payment. Ms O'Neill adds: "You can then withdraw the sum you originally intended to.”

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Cashing in pension funds

Cashing in pension funds should never have been allowed, they get tax relief and employers contributions paid into the fund which should only be available on retirement. They have just turned such pensions into a savings account with all the benefits not intended for such purpose, they later are allowed to claim extra benefits after retirement which Cameron stated would not be allowed.

The problem is actually a lot

The problem is actually a lot worse than you describe, and making a nominal initial withdrawal will not necessarily help. Since the 'emergency tax code' applied is normally your full basic allowance, so making a nominal first withdrawal will not necessarily change your code, merely confirm it. Another issue with this is the charge a provider will make on any withdrawal. So a nominal £1 withdrawal would have cost me £30 in fees (from AJ Bell). Who already had my tax code as 1185L.
The real problem is with the tax calculation formulae that HMRC insist pension providers apply. These are mildly insane: they assume that the first significant amount you withdraw will then be followed by 11 more withdrawals, of the same amount, in the same tax year. So you may be taxed immediately at the higher marginal rate, even though your withdrawal is within your annual allowance and arguably not taxable at all.
Even crazier, this assumption is applied no matter how far into the tax year you make the first withdrawal. So my making a first withdrawal in Month 4 still saw me taxed on an assumed annual total of 12 times that amount. Not 9 times, as would be more logical, and completely ignoring the fact that the amount was well within my tax-free allowance.
Further withdrawals may then include rebates, but not necessarily of the all the tax overcharged. I confess I gave up trying to reverse-engineer these subsequent calculations. Suffice to say I have made 4 withdrawals, in Months 4, 5, 7 (a big one) and 10 (a small one). I got taxed on the 1st and 3rd, rebated on 2nd and 4th. Prior to the 4th withdrawal I was £1500 overcharged on balance, now reduced to £200.
I guess you could recommend making a first withdrawal, specifically in Month 1, of 1/12 of the amount you expect to withdraw that year. But who has pension assets that allow that to happen so neatly? HMRC need to sort this out ASAP. Apart from anything else, the sheer admin costs must be colossal. And all paid for by us.