In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby. Tom is head of retirement policy at A J Bell, the investment platform, and there is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].
This week’s question is from Emily from Newcastle-upon-Tyne. She writes: I’ve taken a £10,000 lump sum out of my pension and by my calculations HMRC has overtaxed me by £3,000. Can this be correct? How do I get my money back?
Tom replies: You might think that when you access your pension pot in line with Government rules, you will pay the correct amount of tax on your withdrawals automatically. Sadly, that is not always the case.
Before getting into why, let’s go through the main retirement withdrawal options. If you have a ‘defined contribution’ (DC) pension, where your pension is invested and then you take responsibility for turning that pot into a retirement income, you can access your pot from age 55. This minimum access age (or ‘normal minimum pension age’) is set to rise to 57 in 2028.
‘Drawdown’ is the most common retirement income route taken by people in the UK. When you commit some of your fund to drawdown, you can also access a separate 25 per cent lump sum tax-free, while any income taken via drawdown will be taxable.
It is also possible to take lump sums directly from your retirement pot as and when you need them, with 25% per cent of each lump sum tax-free and the rest taxed as income.
Finally, you can buy an ‘annuity’ from an insurance company. This guarantees you a certain level of income over the course of your retirement, although you lose the flexibility to manage withdrawals to suit your lifestyle. Buying an annuity also allows you to unlock your 25 per cent tax-free cash entitlement.
You can mix-and-match retirement income options to suit your needs.
When will your withdrawals be overtaxed?
Firstly, your 25% tax-free cash should always be tax-free, regardless of which income option you choose.
If you buy an annuity, HMRC should levy the correct level of tax on your income. The same is true if you receive a defined benefit (DB) pension (a type of pension where you build up a right to a level of income, usually based on your years of scheme membership and salary).
Equally, if you take a regular income from your pension via drawdown, the Revenue should eventually give you an appropriate tax code and deduct the right amount of income tax.
However, if you take a single taxable withdrawal from your pension – either via drawdown or an ad-hoc lump sum (sometimes referred to as a ‘uncrystallised funds lump sum’ or UFPLS) – you will likely be overtaxed by HMRC.
This is because since 2015, when new flexible retirement rules were introduced, HMRC has chosen to tax the first flexible withdrawal someone makes in a tax year on a ‘Month 1’ basis.
This means HMRC divides your usual tax allowances by 12 and applies them to the withdrawal, often landing hard-working savers with shock tax bills running into thousands of pounds.
For those taking more than one withdrawal in the tax year, your tax code should automatically adjust. However, this is not the case where you only make a single taxable withdrawal.
A staggering £970 million has been reclaimed by people who have filled out the correct forms since April 2015. In October, November and December of 2022 alone, more than £45 million was reclaimed by 14,335 people, with an average reclaim of £3,141.
The true figure is likely to be higher as many of those who have been overtaxed will not fill in one of these forms but wait for HMRC to correct the situation at the end of the tax year.
How to get your money back
If you are taking a steady stream of income via drawdown then you shouldn’t need to take any action, as HMRC should alter your tax code to ensure that over the course of the year you are taxed the correct amount.
However, if you make a single withdrawal then you will either need to fill out one of three forms or rely on HMRC putting you in the correct position at the end of the tax year.
Which form you need to fill out will depend on how you have accessed your retirement pot:
If you’ve emptied your pot by flexibly accessing your pension (this usually means taking an ad-hoc lump sum or entering drawdown) and are still working or receiving benefits, you should fill out form P53Z,
If you’ve emptied your pot by flexibly accessing your pension and aren’t working or receiving benefits, you should fill out form P50Z,
If you’ve only flexibly accessed part of your pension pot, then use form P55.
Provided you fill out the correct form HMRC says you should receive a refund of any overpaid tax within 30 days.