Since flexi-access drawdown was introduced in April 2015, HM Revenue & Customs (HMRC) has repaid almost £300m to drawdown savers due to overpaid tax on lump sum withdrawals.
At the end of last month, it announced it had added another £29m to that total between April and June.
This is a colossal amount of money. Worryingly, it isn’t even the total amount of overpaid tax – instead, it’s only the amount repaid when people bother to complete and return the forms claiming back the overpayment. Many others simply wait until the end of the tax year for HMRC to sort it out.
Before April 2015, overpayment of tax wasn’t really a problem. A long-standing HMRC concession meant that lump sums withdrawn from capped drawdown (the predecessor to flexi-access drawdown) were taxed as if they were paid in tax month 12, regardless of when they are actually paid.
But when flexi-access drawdown was introduced HMRC decided to remove this concession, meaning any lump sums paid under pensions freedoms do not receive the benefit of a full year’s tax allowance. Even worse, most first time lump sum payments taken are taxed using the ‘emergency tax code’ or Month 1 basis.
This means in many cases people taking withdrawals from drawdown for the first time pay far too much tax and have to reclaim it from HMRC. They can do this by filling in forms or waiting until the end of the tax year. Either way this is a faff, leading to additional administration for consumers, advisers, and HMRC, and often results in consumers having to make an extra withdrawal to make up any shortfall on the amount they expected.
The Office of Tax Simplification recently highlighted these issues and urged a review of the tax rules, but HMRC is not for budging (just yet) on this issue.
In the meantime, it’s important advisers and their clients understand the tax implications. We have written a factsheet that explains more about how tax is deducted for pension drawdown lump sums, giving clear explanations and examples. It also explains how advisers and their clients can reclaim any overpaid tax using one of three different forms.
We hope you find it helpful.