People who take money out of their pension fund are being over-taxed by Her Majesty’s Revenue & Customs. Since pension freedom began in April 2015, people with money in a pension pot have been able to withdraw some or all of it. More than one and a half million people have done so and between them they have taken more than £17 billion from their pension funds. A lot of these are total withdrawals of the whole fund. It is those who will be wrongly taxed the most.
The withdrawals are good news for the Treasury because tax has to be paid on the money taken out. The first 25% is usually tax-free, but the rest is added to your income in the tax year the withdrawal is made and taxed accordingly. For example, if your income is £18,000 and you withdraw all your pension fund worth £20,000, then £5,000 of that will be tax-free and the balance is added to your income and taxed. In which case you would expect to pay 20% tax on the balance of £15,000, which is another £3,000.
However, HMRC calculates the initial tax rather differently. It assumes that the £15,000 from your pension fund will be a regular monthly income. It then converts that to an annual income, which in this case it would assume was £15,000 x 12 = £180,000. It then taxes you at a higher rate of tax to reflect that income. How much is deducted depends on the time in the tax year you take the money. If you did it in April, then instead of taking off the £3,000 tax that is due, HMRC would deduct tax of more than £5,000 from your lump sum – an extra £2,000 in tax that you do not owe. The calculations are complicated and these are just approximate examples. The exact amount deducted will depend on your tax code and later in the tax year the amount deducted will be less.
The important thing to remember is that the tax deducted from your pension lump sum will almost certainly be too much and you must make sure that you get this money refunded.
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How to get a refund
You can get this money back in one of two ways: Wait until after the end of the tax year in April 2020, by which time HMRC will realise that your annual income is not what it has calculated and give you a tax rebate. Or apply to get the amount refunded right away.
My advice is to get the money back as soon as you can. You may have wanted the money for some specific purpose and allowing HMRC to keep a big chunk of it for a year or more is inconvenient at best. Even if you do not need the money right away, it is better in your hands where you can earn interest on it in a savings account or you may want to invest it. In any event, it is only when you get the correct amount of tax deducted that you know just how much your pension pot is worth.
To reclaim the overpaid tax, you have to fill in a form and the procedure can seem pretty daunting. If you have other income and you have taken all the money from your pension pot, you must use a form called P53Z. You can find it on gov.uk by searching for that code. There are different forms if you have no other taxable income or if you expect to make regular pension withdrawals. Go to gov.uk and search ‘tax on pension lump sum’. That will give you all the options.
Don’t give up…
Nowadays HMRC encourages everyone to sort these tax refunds out online. To do that you will need a Government Gateway account: go to gov.uk/government-gateway. It is quite easy to set this up and it can be used for other things in the future. If you’d rather not do that, you can fill in a form, which HMRC also likes you to complete online but which you then print out and post.
If all this seems a bit fiddly, please don’t give up. The average overpayment reclaimed is more than £2,000. If your pension fund is large, you could be overtaxed by tens of thousands of pounds. However, Government figures suggest that many do give up or simply do not know about the overtaxing problem. Since pension freedom began in 2015 and September 2018, a total of £372.5 million of overpaid tax was refunded using the claims procedure. That sounds like a lot of money, but it is in fact less than 2% of the pension funds that have been taken out. Most of those funds will have had too much tax deducted.
The people who did not claim should have been repaid after the end of the tax year when HMRC finally realised that the pension fund release was a one-off payment not a regular one. But that assumes HMRC gets everything right – an assumption I never make.
…And don’t hang up
If you need help or further information, call HMRC’s Tax Helpline on 0300 200 3300 (open 8am to 8pm Mon-Fri, 8am-4pm Sat and 9am-5pm Sunday). I’ve recently been assured by Mel Stride, the minister in charge of income tax, that the average time for a call to be answered is just under four minutes. That’s much better than it used to be – just be patient.
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