Pensioners overtaxed by £3,540 each due to 'major flaw' in HMRC system - can you claim a refund?

Over 16,000 reclaim forms were processed during the quarter, with an average reclaim of £3,540, the latest figures from HM Revenue & Customs (HMRC) shows.

HMRC's outdated approach has meant that almost £1.3billion has now been reclaimed by people overtaxed on pension withdrawals since 2015.

More than nine years after the pension freedom act was introduced, experts slam the tax system stating "it is inconceivable to think that people are still being overtaxed on their first pension withdrawals".

Due to unnecessary complications in the withdrawal process, many people may have faced "a nasty shock" when their tax bill was way higher than expected.

Jon Greer, head of retirement policy at Quilter said: "There is a major flaw within the PAYE system in that while it works for regular income, the way pensions can be taken does not align with the system's design, and as a result retirees have been heavily impacted since pension freedoms were introduced in 2015.

"It places people on an emergency tax code when they first withdraw from their pension pot, which can present a significant issue for those who were hoping to access their funds quickly."

Supporting this view, Helen Morrissey, head of retirement analysis, Hargreaves Lansdown continued: "It is inconceivable to think that people are still being overtaxed on their first pension withdrawals. Almost £57million has been overpaid in the most recent quarter alone.

"Many of these people will not have been expecting this, and will have had a nasty shock when their tax bill was way higher than expected. This can cause them huge problems: a tax nightmare is not the way to start your retirement."

Tom Selby, director of public policy at AJ Bell, comments: explained that the true overtaxation number will likely be substantially higher especially with people on lower incomes who are less familiar with the self-assessment system.

He continued: “It is simply unacceptable that, almost a decade on from the introduction of the pension freedoms, the government has failed to adapt the tax system to cope with the fact Brits are able to access their pensions flexibly from age 55, instead persisting with an arcane approach which hits people with an unfair tax bill, often running into thousands of pounds, and requires them to fill in one of three forms if they want to get their money back within 30 days."

How to get a refund

There are three forms savers can fill out to claim a refund - the P55, P53Z or P50Z.

Britons should receive their tax back within 30 days of filling in a form. If they don’t do this, the Revenue says it will put them back in the correct tax position at the end of the tax year.

However Morrisey argues "this is a complication many people do not need and it’s a situation that should have been resolved years ago".

How to avoid being overtaxed on your first pension withdrawal

The reason one may be getting overtaxed is because they have been put on an emergency rate of tax whereby HMRC treats it as though that first payment will be repeated every month.

Selby explained that since 2015, HMRC has chosen to tax the first flexible withdrawal someone makes in a tax year on a ‘Month 1’ basis. This means they divide one's usual tax allowances by 12 and applies this to the withdrawal, landing hard-working savers with shock tax bills often running into thousands of pounds.

While those who take a regular income or make multiple withdrawals during the tax year should be put right automatically by HMRC, anyone who makes a single withdrawal will likely be left out of pocket.

There are several steps people can take to help mitigate this issue, including taking several smaller withdrawals rather than an initial lump sum so majority of one's savings will be taxed at the correct amount.

Selby added: "One way savers planning to take a single withdrawal in a tax year can potentially avoid the shock of a big overtaxation bill is by taking a notional withdrawal first. This should mean HMRC is able to apply the correct tax code to the second, larger withdrawal."

The figures released today show there is a growing issue given the huge amount of money that is being repaid as a result of the incorrect amount of tax being charged on pension income.

In Q2 2024, the average tax refund per saver was £3,540 – up by almost £400 compared to Q1.

Greer concluded: “The rising number of claimants represents a large amount of people being over-taxed and waiting unnecessarily for their funds due to a clunky system that is in much need of reform.

"The system is desperately in need of an overhaul as, at present, the process is leaving people facing unnecessary emergency tax and adding additional strain at a time when many are still evidently reliant on their pension funds."