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

People taking money out of their pension pots have had to reclaim £925 million in overpaid ’emergency tax’ since pension freedom reforms were introduced in 2015.

The system has been called “clunky” and “a quiet scandal” by critics, and many have urged the government to make it easier for people to access their own retirement savings without the hassle of back and forth with the IRS.

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

We explain below why HMRC imposes an emergency tax on pensioners and how you can get back overpayments as quickly as possible.

What is the ’emergency tax’ pension trap?

When you make a first withdrawal from a defined contribution pension pool, HMRC assumes it will be the first of many over the remainder of that tax year, which could put you in a higher tax bracket than usual.

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

Retirees get caught if they make a one-off large initial withdrawal, or if they plan to withdraw smaller regular or ad-hoc amounts afterwards.

The withholding tax can be particularly onerous if you make a withdrawal in April, at the start of a new tax year, and do not schedule any further withdrawals.

To get a refund of overpaid tax, you can do so using one of the following three forms – see below.

If you don’t claim proactively, you should get a refund through your tax return after the end of the current tax year, although it can take a long time.

Retirement experts suggest making smaller withdrawals and spreading them out so you’re taxed correctly at the start of retirement rather than having to recoup overpayments later.

Here are links to the forms to use.

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

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

P55 – if you have only withdrawn part of your pot and you are not making regular payments.

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

‘Individuals have the option of reclaiming any overpayment earlier. In the end, no one pays too much tax by using pension flexibility.’

Where an individual does not apply directly to HMRC for reimbursement, it will prepare its annual tax assessment at the end of the tax year as part of its usual reconciliation exercise.

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

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

But since the introduction of pension liberties in spring 2015, giving people much more choice over how they use their retirement savings, around 270,000 forms have been completed and £925 million paid back, according to former Pensions Minister Steve Webb.

“It’s possible that some individuals have completed more than one form,” says Webb, now a partner at LCP and the retirement columnist for This is Money.

However, the £925 million is probably an understatement of the full scale of the problem. Some people who do not fill out a claim form (or do not know that they have to) may not receive a refund until they finally file a report, possibly more than a year later.

“No figures are available on amounts refunded through this route, but it is likely that the total amount of overpayment will exceed £1bn since the system was launched.”

Jon Greer, head of pension policy at Quilter, says overpaid pension tax recoveries in the year to the end of September totaled £131.3m, up from £126.6m the year before as more people were forced to to dive into their retirement pot.

“The figures for the third quarter amount to an average tax refund of £3,324 per saver,” he says. “This is 10 percent more than in the first quarter, which shows that people have to make increasingly larger payments.”

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

“The cost-of-living crisis is bound to lead to an increase in withdrawals, and a subsequent increase in the number of people who are disappointed to have to file a chargeback at a time when they may need the money urgently,” he says. .

Should the system be reformed?

“It remains a silent scandal that tens of thousands of people each year have to fill in forms to get back tax from HMRC that they should never have paid,” says Webb.

“It might be helpful for HMRC to overcharge people and then force them to fill out forms to get their money back, but it doesn’t put the customer first.”

‘A much simpler system would be for tax to be withheld at the base rate with adjustments for those who may pay tax at a different rate, including via the annual tax return. It’s time for this scandal to end.’

Greer says: Despite so many people needing quick access to their money, this clumsy system results in a lengthy process that means people have to wait much longer than they might have expected to receive the full amount they expected.

“The cost-of-living crisis is now putting a great strain on people’s finances, and the number of people needing their retirement savings to make ends meet is likely to continue to rise in the coming months.

“This tax emergency will be particularly frustrating for people trying to access their money quickly to ensure they can afford rising utility bills and other day-to-day expenses, especially if they don’t understand why this has happened.”