Savers who fall into the overtax trap have to wait at least 12 months to get their money back or make an application to HM Revenue & Customs.
The problem can affect anyone who takes a taxable pension freedoms payment from age 55 – either through drawdown or via an Uncrystallised Funds Pension Lump Sum (UFPLS) withdrawal.
In these circumstances, HMRC requires pension providers to use an emergency “Month 1” tax code. This means the revenue only gives you 1/12th of the usual tax allowances available on the withdrawal, resulting in many savers being severely overtaxed.
According to AJ Bell, £283m (€325m $399m) in overpaid tax has been repaid to pension savers so far and the average overpayment is £2,420.
“Tens of thousands of people using the pension freedoms every month risk falling into this tax trap. On average, the level of over-taxation runs into thousands of pounds and for some it could be tens of thousands of pounds,” said Tom Selby, senior analyst at AJ Bell.
“The problem is at its most acute at the beginning of the tax year as anyone who makes an ad-hoc withdrawal and doesn’t fill out the right form to claim the money back will have to wait until at least April 2019 to get their money back. Even then, you are relying on the efficiency of HMRC to put you back in the position you should have been in in the first place.
Selby said this no small issue as according to HMRC data, around 140,000 pension pots have been accessed for the first time every quarter since the pension freedoms were introduced.
“The vast majority of these are likely to have been taxed on a ‘Month 1’ basis.
“However, on average, only 10,500 official reclaim forms have been processed each quarter by HMRC, worth a total of £283 million.
“This is not an academic problem either – savers accessing their pensions for the first time using the freedoms understandably expect to receive the correct amount of money. Many will have specific plans for their withdrawal, such as to pay down debt or fund long-term care for an elderly relative. For people like this, getting thousands of pounds too little will present a serious financial challenge.
“HMRC should, at the very least, consult on its approach to single pension freedoms withdrawals and review the risks it poses to savers. Allowing providers to apply a ‘Month 12’ tax code would be a more consumer-focused solution, with HMRC taking responsibility for recouping any underpaid tax,” Selby said.