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

People who withdraw from pension funds have had to recoup £925m in excess contingent tax since the introduction of freedom pension reforms in 2015.

Critics have called the system “distrustful” and a “quiet scandal,” and many have urged the government to make it easier for people to access their pension savings without having to shell out money with taxpayers.

More people are likely to fall into this bureaucratic trap as more and more people use their pension pots for the first time to cover rising household bills.

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Below we explain why HMRC imposed an emergency tax on retirees and how to recover the overpayment as quickly as possible.

Plan ahead: Pension experts suggest making smaller withdrawals and spreading them out, so you’re properly taxed at the start of retirement.

What is the “emergency tax” pension trap?

When you make an initial withdrawal from a defined contribution retirement pool, HMRC assumes it will be the first of many for the remainder of that tax year, which could push you into a higher-than-usual tax range.

Therefore, it applies a contingent tax rate on the basis that this may be the “first month” of the series of withdrawals.

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Retirees are stopped if they make a large one-time first withdrawal, or if they intend to take regular or earmarked small amounts afterwards.

The tax withholding can be particularly onerous if you made a withdrawal in April, at the start of a new tax year, and didn’t plan for any other year.

To recover an overpayment of tax, you can do so using one of three forms – see below.

What is freedom pension?

Pension freedom reforms have given over-55s more power over how they spend, save or invest their pensions.

Major changes from April 2015 included eliminating the need to purchase an annuity to save income until your death, providing access to investment and withdrawal schemes previously restricted to the wealthiest savers, and eliminating the 55 percent “death tax” for pensioners. left invested.

The changes apply to people with “defined contribution” or “money purchase” retirement schemes, which take contributions from both employer and employee and invest them to save some amount of money in retirement.

It does not apply to those with generous, gold-plated final salaries or ‘defined benefit’ pensions which provide a guaranteed income post-retirement.

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However, those still saving in such schemes can switch to DC schemes, provided they get financial advice if their total is worth over £30,000.

If you don’t preemptively claim, you should get your refund through your tax return after the end of the current tax year, though this can take a long time to wait.

Pension experts suggest making smaller withdrawals and spreading them out, so you’re properly taxed at the beginning of retirement rather than having to make up overpayments later.

Below are links to the templates to use.

P50Z – If the payment exhausts the pension amount and you have no other income in the tax year

P53Z – If the payment exhausts the pension amount and you have other taxable income

P55 – If you have withdrawn only a portion of your pot and have not been making regular payouts.

A spokesperson for HMRC says: ‘Anyone who ends up paying more tax than they should due to the emergency tax law in place will be automatically paid off at the end of the year.

Individuals have the option to refund any earlier overpayments if they wish. Ultimately, no one will pay more taxes as a result of benefiting from the flexibility of pensions.

When an individual does not apply directly to HMRC for a refund, they will work out their annual tax bill at the end of the tax year as part of the normal settlement process.

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

Around 10,000 of the above forms were submitted in the three months to the end of September, and people received around £33m back.

But since the launch of Pension Freedoms in the spring of 2015, giving people much greater choice about how to access their pension savings, some 270,000 forms have been filled out and £925m has been recovered, according to former pensions minister Steve Webb.

“Some individuals may have filled out more than one form,” says Webb, now a partner at LCP and pension columnist for This Money.

However, £925m is likely to be less than the full scale of the problem. Some people who don’t fill out a claim form (or don’t know they have to) may only get a refund when they finally fill out a tax return, perhaps more than a year later.

It may be convenient for HMRC to tire people out and then force them to fill out forms to get their money back, but it hardly puts the customer first.

Steve Webb, Partner, LCP

“There are no figures available for refunds through this route, but it is likely that the total amount of overpayments has been more than £1 billion since the scheme began.”

John Greer, head of retirement policy at Quilter, says recoveries from excess pension tax were £131.3m in the year to the end of September, up from £126.6m a year earlier as more people had to dip into their pension pots. .

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

Greer points out that the trend in these numbers only shows pension withdrawals that include a taxable component, and doesn’t cover instances of tax-free cash only taken out.

“The cost-of-living crisis will undoubtedly lead to an increase in withdrawals, and a subsequent increase in the number of people who are left disappointed because they have to reclaim their right at a time when they may need the money urgently,” he says. .

Should the system be reformed?

“It remains a quiet scandal that tens of thousands of people each year have to fill out forms to get back taxes from HMRC that they never had to pay in the first place,” says Webb.

“It may be convenient for HMRC to tire people out and then force them to fill out forms to get their money back, but that hardly puts the customer first.”

A much simpler system would be to deduct tax at the base rate with adjustments for those who might pay tax at a different rate, including through the annual tax return process. It’s time for this scam to end.

Although many people need quick access to their money, Greer says, this corrupt system results in a lengthy process that means people have to wait much longer than they would have expected to receive the full amount they expected.

The cost of living crisis is now putting a real strain on people’s finances, and the number of people needing access to their pension savings to help them live is likely to continue to rise in the coming months.

This emergency tax situation will be especially frustrating for people trying to get to their cash quickly to ensure they can pay mounting energy bills and other daily costs – especially if they don’t understand why this is happening.

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