New figures released this week showed HMRC has overtaxed people who take money out of their pension to the tune of over £1billion since 2015.
More than £48million was repaid to 15,856 people overtaxed on pension withdrawals in the first three months of this year.
This figure was a huge increase from the same period last year which saw pensioners receive £22million in tax refunds.
Steve Webb, a former pensions minister and now partner at LCP described HMRC's current system as a "disgrace".
He added: "A system based on systematic over-taxing of pension savers cannot be right.
"There is no good reason why citizens who access their pension should have to go through the hassle of claiming back excess taxation which they should never have had to pay in the first place."
HMRC told The Mirror no one "overpays" by taking advantage of pension flexibility and that anyone who makes a tax overpayment can claim it back anytime.
The Mirror explains why pensions are being taxed this way and what you can do to make sure do not need to hand over more than your fair share of tax.
Why are pensions being overtaxed?
This issue has been around for a few years and is related to new pension freedom rules which were introduced in 2015.
The idea is that people can withdraw some of their defined contribution pension savings as an income from the age of 55, while leaving the rest untouched.
Pension drawdown, which is also known as income drawdown or flexi-access drawdown, is supposed to give savers a flexible way of taking cash out of their pension pots.
Rather than buying annuity, you can move your pension savings into a drawdown product which will let you take cash when you need it - each time you move your pension into a drawdown, 25% of it is tax free.
Since April 2015, HMRC has chosen to tax the first flexible withdrawal you make from your pension pot in the tax year and the first is called "month one".
HMRC then divides your usual tax allowances by 12 and applies them to the withdrawal as if you will withdraw this amount every month of the tax year - because of this, the rate is classed as an emergency tax code.
As a result, just one-twelfth of your personal allowance is applied to the payment, with the remainder assessed against one twelfth of the income tax bands in place.
If you are taking more than one withdrawal in the tax year, then your tax code should automatically adjust but if you make just one withdrawal, it won't.
A lot of retirees get caught out if they make a large first withdrawal as a one-off and they intend to take smaller regular amounts thereafter.
If I withdraw from my pension early how much will be taxed?
So what does this look like in numbers? Here is an example by insurance firm Royal London.
If you want to take out £50,000 from your pension pot, you can get a 25% of that amount tax free.
This means £12,500 of this amount is tax free, whilst the remaining £37,500 is subject to tax.
As HMRC treats the withdrawal as if you are going to pull £50,000 out every month and will treat you as if you are an additional rate taxpayer - and not eligible for the personal allowance.
This means you would end up with a tax bill of above £15,000 and as a result, you would only see less than £35,000 of your lump sum.
The exact level of tax you would have to pay does depend on your personal circumstances and income tax band - so not everyone will see a tax bill of £15,000.
According to the recent HMRC data, the average amount reclaimed in the first few months of this year came to £3,062 per person - which is slightly down from last year.
Pension experts say the amount in the average refund refunds suggests that savers are pulling out smaller amounts from their pension pots.
How can I claim my overpaid pension tax back?
If you are taking a steady stream of income through the pension drawdown then you shouldn't need to take any action as HMRC will adjust your tax code to ensure that over the course of the year, you are taxed the correct amount.
If you do just make a one-off withdrawal, then you have a couple of options.
The easiest option is to wait for HMRC to put you in the correct position at the end of the tax year when you file your self-assessment.
After a review of your tax return, HMRC will see that the emergency tax code has been issued and will return the money to you.
However, the con of this is you could be waiting a long time to get your cash back, which isn't ideal for people who need the money sooner rather than later.
Another option you can take is to claim it back yourself.
To do this, you will need to fill out one of three different forms - which will depend on how you have accessed your retirement pot and your personal circumstances:
- P53Z form - If you’ve emptied your pension pot and are still working or receiving benefits
- P50Z form - If you’ve emptied your pension pot and aren’t working or receiving benefits
- P55 form - If you’ve only accessed part of your pension pot
You can get these forms on GOV.UK.
You can fill out these forms online or you can send them in the post.
If filled out correctly, HMRC says you will get your tax refund within 30 days.
How you can avoid being overtaxed on your pension withdrawals?
Even with pension experts calling for reform in the system, HMRC doesn't look like it will make any changes in the foreseeable.
Because of this, if you are accessing your pension you will need to take into consideration the tax repercussions of it and there are ways you can work around it.
One common piece of advice from pension experts is to take out a smaller amount from your pension pot if you are pulling out cash for the first time.
Andrew Tully, technical director at Canada Life suggests this amount should be around £100.
He explains: “That will generate a tax code from HMRC which the pension provider will apply to any subsequent withdrawals.
"That will result in the tax being taken at source being far more accurate in many more cases, not only reducing the burden of paperwork but equally importantly the customer receiving a more accurate withdrawal in the first place.”
