Tax charge trap for pension withdrawals

Post by Mearns & Company in News

Pension freedom rules have given people earlier and more flexible access to their retirement savings. However, many are paying too much tax when they first make a withdrawal, due to the way HMRC’s computer systems operate.

Latest HMRC data shows it processed 12,000 reclaim forms in the last three months of 2023, relating specifically to this issue.  In total HMRC paid back nearly £39m to savers who have been overtaxed on pension withdrawals, making the average rebate £3,216.

The issue arises when savers first make a withdrawal from a drawdown plan. HMRC software assumes that the money taken will be a regular monthly withdrawal, and effectively taxes it accordingly, via an emergency tax code.

In many cases, however, people aren’t taking this as a regular payment. Instead they are using the pension freedom rules to make one or more ad-hoc withdrawals – perhaps to pay for a holiday, home improvements or reduce debts – and as a result end up with a smaller sum due to this taxation issue. For example, if you were withdrawing £10,000 at the start of the financial year the tax code would assume an annual income of £120,000.

This problem occurs when people are taking flexible lump sums from their pension, known as uncrystallized fund pension lump sum (UFPLS) payments. But this tax trap doesn’t apply to all pension withdrawals. For example, it won’t apply if you are taking your tax-free lump sum (known as the pension commencement lump sum: people from the age of 55 can withdraw up to 25% of their savings tax-free). And if you are taking a monthly income, via a drawdown plan, then the tax should be broadly correct, although there may be some adjustments to be made, depending on any other income you receive.

Tax rebate

If you have made a one-off withdrawal from your pension and are concerned you may have paid too much tax, you can get this money back. The quickest way to do this is by completing one of HMRC’s tax reclaim forms. You need to complete either a P55, P53Z or P50Z form depending on your circumstances. All three are available on HMRC’s website.

Provided you complete the correct form, HMRC states that it aims to process these refunds within a 30-day window. Those who don’t complete a form should have this tax readjusted in the following year, via the self-assessment process.

If you are planning to make a flexible withdrawal from your pension plan in the near future, there are steps you can take to try to avoid this problem. The best way is to make a very small initial withdrawal. The temporary tax code is then imposed on this smaller sum, and will be reapplied to the second, larger withdrawal. There may still be some adjustments to make, but it is unlikely to result in such a large overpayment.

The Financial Conduct Authority does not regulate tax advice. Tax treatment varies according to individual circumstances and is subject to change.