‘Quiet scandal’ of emergency pension tax – and how to avoid it

People making withdrawals from retirement pots have had to reclaim £925million in overpaid ’emergency tax’ since pension freedom reforms were introduced in 2015.

The system is dubbed ‘clunky’ and ‘a quiet scandal’ by critics, and many have urged the Government to make it easier for people to access their own pension savings without this to-ing and fro-ing of funds with the taxman.

Many more people are likely to fall into this bureaucratic trap as an increasing number tap their pension pots for the first time to cover rising household bills.

We explain below why HMRC slaps emergency tax on retirees and how to get overpayments back as swiftly as possible.

What is the ’emergency tax’ pension trap?

When you make an initial withdrawal from a defined contribution pension pot, HMRC assumes it will be the first of many over the rest of that tax year, which could push you into a higher tax band than normal.

It therefore applies an emergency tax rate on the basis that this could be ‘month one’ of a series of withdrawals.

Retirees get caught out if they make a large first withdrawal as a one-off, or if they intend to take smaller regular or ad-hoc amounts thereafter.

The tax deducted might be particularly onerous if you make a withdrawal in April, at the start of a new tax year, and don’t plan any further ones.

To get a tax overpayment back, you can do so using one of three forms – see below.

If you don’t proactively claim, you should get a refund via your tax return after the end of the current tax year, though this can be a long time to wait.

Pension experts suggest making smaller withdrawals and spreading them out, so you are taxed correctly at the start of retirement rather than having to claw overpayments back later.

Here are links to the forms to use.

P50Z – if the payment used up your pension pot and you have no other income in the tax year

P53Z – if the payment used up your pension pot and you have other taxable income

P55 – if you have withdrawn only part of your pot and you’re not taking regular payments.

An HMRC spokesperson says: ‘Anyone who ends up paying more tax than they should due to an emergency tax code being applied will automatically be repaid at the end of the year. 

‘Individuals have the option of claiming back any overpayment earlier if they wish. Ultimately, nobody will overpay tax as a result of taking advantage of pension flexibility.’

Where an individual does not apply directly to HMRC for a refund, it will work out their annual tax bill at the end of the tax-year as part of the usual reconciliation exercise. 

How many people are affected – and how much have they overpaid?

Around 10,000 of the forms above were submitted in the three months to the end of September, and people reclaimed around £33million.

But since pension freedoms were launched in spring 2015, allowing people much greater choice over how they access their retirement savings, around 270,000 forms have been filled in and £925million has been refunded, according to former Pensions Minister Steve Webb.

‘It is possible that some individuals may have filled in more than one form,’ says Webb, now a partner at LCP and This is Money’s pensions columnist.

‘However, the £925million is likely to be an understatement of the full scale of the problem. Some people who do not fill in a claim form (or do not know they have to do so) may only get a refund when they eventually fill in a tax return, possibly over a year later.

‘No figures are available for the amounts refunded through this route, but it is likely that the total amount of overpayment will be well over £1billion since the system began.’

Jon Greer, head of retirement policy at Quilter, says pension tax overpayment reclaims totalled £131.3million in the year to the end of September, up from £126.6million the year before as more people have been forced to dip into their pension pots.

‘The third quarter figures amount to an average tax reclaim of £3,324 per saver,’ he says. ‘This is 10 per cent higher than in the first quarter, which shows people are needing to take increasingly larger payments.’

Greer points out that the trend in these figures only shows pension withdrawals that include a taxable element, and does not cover cases of tax-free cash only being taken.

‘The cost-of-living crisis will no doubt result in an increase in withdrawals, and a subsequent increase in the number of people left disappointed that they have to make a reclaim at a time when they may urgently need the money,’ he says.

Should the system be reformed?

‘It remains a quiet scandal that tens of thousands of people every year have to fill in forms to get back tax from HMRC which they should never have had to pay in the first place,’ says Webb.

‘It may be convenient for HMRC to overtax people and then force them to fill in forms to get their money back, but it is hardly putting the customer first.’

‘A much simpler system would be for tax to be deducted at the basic rate with adjustments for those who may pay tax at a different rate, including through the annual tax return process. It is time for this scandal to end.’

Greer says: Despite so many people needing quick access to their funds, this clunky system results in a drawn-out process that means people have to wait far longer than they may have anticipated to receive the full amount they expected.

‘The cost-of-living crisis is now putting a real strain on people’s finances, and the number of people needing to access their pension savings to help them get by will likely continue to rise in the coming months.

‘This emergency tax situation will be particularly frustrating for people trying to access their funds quickly to ensure they can pay for rising energy bills and other everyday costs – particularly if they don’t understand why it has happened.’