I'm taking a lump sum from my pension - how can I avoid overpaying tax? (2024)

A reader wants to know how they can avoid having to contact HMRC to claim back tax on their pension

May 14, 2024 6:00 am(Updated 11:37 am)

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Neet emailed: The HMRC seems to assess that any lump sum taken from a pension means you are earning or receiving that sum as a monthly salary. This often results in you being overcharged on tax and then you have the hassle of contacting HMRC to reclaim the overpayment. All of this takes considerable time and undue delay. Can you get a tax number that you can give in advance so they only take the right amount and avoid a reclaiming the overpaid tax?

Paul replies: Neet, you have identified not so much a problem as a scandal. Since 2015, HMRC has taken billions of pounds of tax in overpayments from millions of pension payments and only given it back up to a year or so later.

Since 2015, anyone aged 55 or over has had the right to take money from their pension pot and use it as they wish. Official figures show that from then to April 2023, nearly two and a half million people have withdrawn more than £72bn – an average of around £31,000 each but often taken in several chunks. Just about all of that money will have had too much tax taken off it.

The reason for that is simple. When you take out a lump sum, HMRC assumes that it is a new monthly income and your pension provider must therefore deduct a lot of tax from it before it sends you the cash. Here is how the HMRC arithmetic works.

Say you have an income of £24,000 a year. Your pension pot is £35,000 and you decide to take it all out. A quarter of this amount can be withdrawn tax-free, leaving £26,250 to be taxed.

This should be added to your annual income and taxed at the basic rate of 20 per cent because your annual income is below the threshold of £50,270 where higher rate tax begins in most of the UK.

However, the computers at HMRC assume the same amount will be paid every month, which would add around £315,000 to your annual income – the whole taxable £26,250 added to your other income every month for 12 months.

That would be taxed mainly at the higher and additional rate of 40 per cent and 45 per cent, respectively, and so HMRC takes too much tax off your pension and then at some stage gives it back to you.

The investment and pensions specialist Fidelity calculates that on those figures, tax of £10,087 would be deducted by the pension provider before it passes the money on to you which, it says, is £4,837 more tax than should be paid. You can put your own figures in at Fidelity’s pension tax calculator to see how much you should be paying.

Any such calculation is an approximation and will depend on each person’s personal circ*mstances, as the very long “assumptions” document on the website makes clear.

The situation is even worse in Scotland, where higher-rate tax is 42 per cent and begins at an annual income of £43,663, with the highest rate of tax at 48 per cent.

Despite the frustration, don’t blame your pension provider – it is legally obliged to deduct the tax on what is called a month one basis. That means assuming that this month’s income will continue every month for the future. There is no prospect of this methodology changing. For the foreseeable future, HMRC will be taking, often, thousands of pounds too much tax from pension lump sums withdrawn by people over 55.

Neet, you say you “reclaim the overpayment”. That is called an “in-year” refund and is done by filling in a form. I’m sure you know which one to use, but just to make things difficult for newcomers there is a choice of three – called P55, P53Z, or P50Z.

You can find out which one you need by searching “tax refund flexibly” on gov.uk and then working out which is right for your circ*mstances. You will also need a P45 from your pension provider, which it should have sent you anyway. HMRC will work out what it owes you and rather quaintly send you a cheque – what it calls a payable order.

In 2023/24, HMRC sent people £200m worth of these bits of paper for tax that had been overpaid on pension withdrawals. Since pension flexibility began in 2015, people have sent in more than 430,000 forms and been refunded more than £1.2bn in overpaid tax. That seems a big number, but only about one in 50 pension payments result in an in-year refund claim.

You ask if there is an alternative to avoid this hassle. As I said, it is baked into the system so there is no magic number you can get to stop it happening. But there is an alternative. Do nothing!

At the end of the tax year, HMRC will realise that its prediction of your regular monthly income was wrong and will send you a form P800 with a refund. That is easier than claiming, but it does mean HMRC has a big chunk of your pension money for up to a year, which could be earning 5 per cent in a deposit account if you had it instead. HMRC will not normally pay any interest on the money it has held for up to a year or more.