In the past three months, when non-retired taxpayers withdrew funds from their pension accounts, a total tax bill of £56 million was generated, reaching a historic high. However, this data is inflated and does not represent the actual tax revenue from pension withdrawals.
The latest HMRC data shows that from April to June of this year, nearly 16,000 refund applications were processed, with an average overpayment of £3,551 per claim. This figure marks the second-highest peak since the implementation of the pension freedom policy in 2015. The reason for the significant overpayment in taxes is due to HMRC’s method of taxing pension withdrawals.
HMRC taxes the first flexible pension withdrawal made by an individual in the tax year as ‘Month 1’, instead of calculating the annual tax-free withdrawal allowance. In other words, when HMRC receives an application for pension withdrawal, they divide the individual’s annual tax allowance by 12 and apply it to the withdrawal amount. Any excess over the average monthly tax-free withdrawal amount is subject to taxation.
The drawback of this calculation method is that it overlooks the fact that people may have different preferences for how to withdraw their pension. Some may choose to divide their annual tax-free withdrawal allowance into 12 equal portions and withdraw one portion each month (which is the method subject to this calculation), while others may opt to withdraw the entire tax-free allowance in a single lump sum.
Taxpayers who choose to withdraw a large amount of money in a single withdrawal will lose a substantial portion of it to taxes at the time of withdrawal, compared to those who make fixed monthly pension withdrawals. Although any excess tax paid will be refunded to the taxpayer at the end of the tax year, within the short term (30 days), if taxpayers want to reclaim their money, they need to fill out three HMRC forms to apply for a refund.
Tom Selby, Head of Retirement Policy at AJ Bell, stated that this complex and unreasonable process reflects the fact that the UK government has not fully adapted to the fact that UK taxpayers can flexibly access their pensions from the age of 55. The current tax refund process appears outdated, as people are forced to pay substantial amounts of tax in the short term and must navigate a relatively cumbersome procedure to reclaim it within 30 days.