£600 million reclaimed from pension freedom tax trap

Those taking advantage of the pension freedoms for the first time are in danger of being hit by a punitive 'emergency tax'. 

Since the pension freedoms were introduced five years ago, a total of £600 million has been reclaimed by savers hit by a punitive ‘emergency tax’.

The freedoms have enabled people to withdraw as much of their pension as they want, but if they withdraw a large lump sum, or even the whole pension, on their first withdrawal they are in danger of being charged an ‘emergency tax’, which they then have to reclaim from HMRC if they don’t want to wait until the end of the tax year to be reimbursed.

Figures from HMRC show there were 10,000 claim forms processed in the first three months of 2020, with the average refund amount £3,141. In total, £600 million has been reclaimed since the freedoms took effect in April 2015.

Overall, 348,000 people accessed their defined contribution (DC) pension pot in the first quarter of 2020 – an increase of 23% over the same period last year.

Those accessing their pension for the first time during that period may have been overtaxed, so it is worth checking if this applies to you and then reclaiming any overpayment through a Government Gateway account. See the lower down the article for more on reclaiming.   

This overtaxation problem persists because, after five years of pension freedoms, HMRC is still applying its ‘Month 1’ approach to the taxation of withdrawn pension funds. Under this system, the initial withdrawal will be treated by the pension provider as the first of 12 monthly withdrawals, so the usual tax allowances are divided by 12 and applied.

Tom Selby, senior analyst at AJ Bell, says:  “While the freedom and flexibility pensions now offer has been welcomed by millions, HMRC’s insistence on applying a ‘Month 1’ emergency tax code to the first withdrawal of the tax year has now seen savers reclaim £600 million in overpaid tax.

“It’s worth remembering this only covers those who have made a reclaim using the official forms, and so doesn’t include any people refunded via HMRC’s systems at the end of the tax year.

“Anyone planning to access their pension in the new tax year – including those looking to use their retirement pot to plug an income gap resulting from COVID-19 – needs to be aware of the impact Month 1 taxation will have on the amount of money they receive initially.”

How to reclaim overpaid tax 

You can set up a personal tax account using Government Gateway here: https://www.gov.uk/personal-tax-account.

Alternatively, instead of claiming through Government Gateway, you can download the necessary form from gov.uk. But make sure you use the right form for your circumstances.

P50Z – if you have emptied your pension and have no other income in that tax year.

https://www.gov.uk/government/publications/income-tax-claim-for-repayment-of-tax-when-youve-stopped-working-and-flexibly-accessed-your-pension

P53Z – if you have emptied your pension but have other taxable income.

https://www.gov.uk/government/publications/income-tax-repayment-claim-when-small-pension-taken-as-a-lump-sum-p53

P55 – if you haven’t emptied your pension pot and you won’t be taking regular payments.

https://www.gov.uk/government/publications/flexibly-accessed-pension-payment-repayment-claim-p55