Thousands of retirement savers drawing cash from their pensions are paying too much tax because of a loophole in tax law, according to financial experts.
A quirk in the way tax is worked out means anyone who has taken money from their pension savings will have paid income tax – but only 11,000 claims for a refund have been made even though an average 139,000 pensions are dipped into for cash every quarter.
And as pension freedoms allowing the withdrawals started in April 2015, that could add up to a million savers owed money by HM Revenue and Customs (HMRC).
Tax coding quirk
The issue is tax coding, says financial platform AJ Bell.
HMRC must supply an accurate tax code to a pension provider so the right amount of tax is deducted at source from the cash withdrawal.
However, HMRC does not routinely supply the codes and providers cannot accept them from customers.
Instead, providers must resort to a default tax deduction called the ‘month 1’ basis.
Under this default, the pension withdrawal is treated as a regular monthly payment instead of a one-off transaction. Tax rules then say the annual tax allowance is divided equally over 12 months.
No help from HMRC
For a £10,000 withdrawal at the start of the tax year, a pension saver with no other income for the year should expect to pay no income tax. But under the month 1 rule, they pay £3,099 as the £10,000 is tax treated as the first instalment of £120,000 over the year.
“HMRC insists an emergency tax code is applied to pension freedom withdrawals, which means tens of thousands of people will have paid too much tax on their withdrawals, yet few have reclaimed this tax. This might be because they don’t know they have paid too much or because the process to reclaim it just seemed too complicated,” said Tom Selby, a senior analyst at AJ Bell.
“Whatever the reason, there is likely to be millions of pounds sitting with HMRC that could be legitimately reclaimed. It is up to individuals to check whether they have paid too much tax and to make a claim, they are unlikely to get any help from the government.”
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