Ex-pensions minister warns retirees could be over-taxed during lockdown

There are fears savers could end up paying double tax to access their pots during the coronavirus outbreak.

Savers could end up paying tax twice if they dip into their pension pots due to the coronavirus pandemic.

Research by pensions consultancy LCP suggests that this ’over-taxation’ is likely to get more severe during the current crisis as savers look to withdraw lump sums.

Since the introduction of pension freedoms in 2015, people aged 55 or over with defined contribution pensions have been able to take money flexibly from their retirement pot rather than use it to buy a regular income. 

Around a third of a million people took money out of their pension in this way in the first quarter of 2020, according to statistics from HM Revenue and Customs (HMRC).

Over-taxation is unlikely to be a problem for people making modest withdrawals on a regular basis.

But for those taking a one-off sum from a pension pot the excess tax could run into thousands of pounds.

This is because when HMRC taxes savers it assumes they are going to make repeated withdrawals rather than just one.

When a pension pot is all taken out in one go the first 25% is usually tax free but the balance is subject to income tax. However, HMRC requires an emergency tax code for this type of pension withdrawal which effectively taxes people upfront.

Steve Webb, partner at LCP, says “It is already unacceptable that HMRC routinely over-taxes thousands of people on one-off withdrawals from their pension pots, leaving them to fill in forms to claw back the excess tax that they have paid.

“But in the current crisis, this system will be even more penal. Lots of people who lose their jobs or suffer wage cuts will have reduced taxable income in 2020/21.  As a result, they should be paying less tax on these withdrawals.”

Scale of the problem

LCP gives an example of a saver cashing out a pension pot of £40,000. Of the total, £10,000 can be taken tax-free, and the balance of £30,000 is taxable.

A basic rate taxpayer should be taxed at 20% and pay a £6,000 tax charge.

However, the pension scheme would currently deduct almost £12,000 in tax – around double the correct amount.

The extent of over-taxation will depend on how much other income you have during the course of the financial year.

The less you have in other taxable income, the more you are being over-taxed on your withdrawal.

Table to show extent of over-taxation

Source: LCP May 2020

Can you claim the money back?

Fortunately for pension savers the excess money paid in tax can be claimed back.

HMRC has had to repay more than £600 million in over-paid tax on pension withdrawals since 2015. 

In the first three months of this year HMRC processed over 10,000 claims from people who had reclaimed the overpaid tax as soon as it was deducted, getting back over £3,000 each on average.

Time for change

Webb says the tax system needs to change so that pension savers are penalised for dipping in their pots.

He says: “Whilst it is far from ideal if individuals feel they have no choice but to access their pensions to support them through the current crisis, the very least the authorities should do is allow fairer tax deductions upfront on them.

"The system of ‘emergency tax’ on one-off withdrawals from pension pots has already been widely criticised and it now looks unfit for purpose in the current crisis. HMRC should think again as a matter of urgency.”