page-banner

HMRC
over-taxing of pension withdrawals ‘set to get more penal during lockdown’

Media centre

As millions of families face increased financial pressure during the current crisis, more of those aged 55 or over may be considering accessing their pension “flexibly” for additional funds. What many people may not realise when they encounter the system for the first time is that HMRC may require the pension provider to deduct tax in a way that means for tens of thousands of people each year more is deducted than the amount actually due. And new research by pensions consultancy LCP suggests that this ‘over-taxation’ is set to get more draconian during the current crisis.

Since the introduction of pension freedoms in 2015, individuals aged 55 or over have been able to take money ‘flexibly’ from their pension pot rather than use the pot to buy a regular income. According to HMRC statistics roughly a third of a million people took money out of their pension in this way in the first quarter of 2020. Many of these withdrawals will be by people in retirement taking relatively modest amounts on a regular basis where over-taxation is unlikely to be an issue. But for those who first take a one-off sum from a pension pot, the excess tax can run into thousands of pounds.

When a pension pot is all taken out in one go (and in the case of some other lumpy withdrawals), the first 25% is usually tax free but the balance is subject to income tax. However, HMRC in general requires use of an ‘emergency tax code’ for this type of pension withdrawal. This has the effect of taxing people upfront as if they were going to make repeated withdrawals rather than just a one-off withdrawal. This assumption often means that they pay ‘excess’ tax which they then have to reclaim.

HMRC have had to repay more than £600m in over-paid tax on pension withdrawals since 2015. In Q1 2020 alone HMRC processed over 10,000 claims from people who had reclaimed the overpaid tax as soon as it was deducted, and the taxpayers received back an average of over £3,000 each. And this only reflects people who actively claimed a refund - no figures are available on the numbers who do not claim at the time and so are only refunded after the end of the financial year.

To give an example of the potential scale of the problem on a larger pot, take a member cashing-out a pension pot of £40,000. Of the total, £10,000 can be taken tax-free, and the balance £30,000 counts as taxable. If, allowing for this, the individual is a basic rate tax payer, the taxable balance should be taxed at 20% ie a tax charge due of £6,000, meaning the member should end up with £34,000. However, the pension scheme would currently have to deduct almost £12,000 in tax – around double the correct amount – leaving the member with only £28,000 (until they could reclaim the excess)

The correct tax bill on this withdrawal would depend on how much other taxable income the individual had over the course of the financial year. The table below shows what the correct tax bill would be (and how much of a refund would be due) on three different assumptions about the individual’s other taxable income in the year.

Other taxable income during 2020/21 Actual tax deducted on pension withdrawal (£40k pot of which £30k taxable) Correct tax on pension withdrawal Refund due
£12,500 £11,781 £6,000 £5,781
£25,000 £11,781 £7,000 £4,781
£50,000 £11,781 £12,000 [-£219]

 

As the table shows, the extent of over-taxation depends on how much other income people have during the course of the financial year. The less you have in other taxable income, the more you are being over-taxed on your withdrawal.

In the current crisis, many people may lose their jobs or have depressed wages. This means that far more people will have lower taxable income over 2020/21 than would normally be the case. But HMRC will go on deducting exactly the same amount from these pension pot withdrawals as they have always done. This means that for many of these people the tax deducted before the pension is paid out is likely to be significantly more than the correct amount of tax due. In short, for many people, the whole way in which pension pot withdrawals are taxed is set to get more penal in the midst of the current crisis.

Commenting, Steve Webb, partner at LCP said:

“In my view, it is already unacceptable that HMRC routinely over-taxes thousands of people on one-off withdrawals from their pension pots, leaving them to fill in forms to claw back the excess tax that they have paid. But in the current crisis, this system will be even more penal. Lots of people who lose their jobs or suffer wage cuts will have reduced taxable income in 2020/21. As a result, they should be paying less tax on these withdrawals. But HMRC is going to carry on taking exactly the same amount of tax upfront as it has always done. This means that hard-pressed individuals will be over-taxed by more and will have to claim back more money – tax that they didn’t owe in the first place.

“This system has to change. Whilst it is far from ideal if individuals feel they have no choice but to access their pensions to support them through the current crisis, the very least the authorities should do is allow fairer tax deductions upfront on them. The system of ‘emergency tax’ on one-off withdrawals from pension pots has already been widely criticised and it now looks unfit for purpose in the current crisis. HMRC should think again as a matter of urgency”.