HMRC has advised that they processed 42,046 tax repayment claim forms purely in relation to flexible pension withdrawals in 2021.  

    If you think that's a scary number, then you might be equally shocked to learn that the claims amounted to an eye-watering £143m of overpaid tax having to be repaid to claimants during the year.

    Many who've overpaid may yet still make a claim for repayment through their annual tax return or be waiting for HMRC to work out the amount to be refunded, therefore the figure is likely to be much higher.

    The fact that pension freedoms will have been with us for seven years come April you would've thought that a fairer and less cumbersome solution for the taxpayer could've been put in place by now. However, the limitations of the PAYE system continue to stack the cards well and truly in favour of HMRC, giving them a generous cashflow benefit.

    One would've hoped that our income tax system could be more sympathetic and less onerous for those in retirement, however, the reality is the outcomes can sometimes be nonsensical, or even perverse.

    I get a lot of enquiries from advisers wanting to know what net income their client will receive if they take an ad-hoc payment from their pension. While working out the overall tax liability on an ad-hoc payment isn't particularly complex, the problem lies with the PAYE system, as it was never designed to facilitate such a strategy.

    On a regular withdrawal basis the process works well, but as soon as you introduce ad-hoc withdrawals into the mix, the system stumbles. The main issue with the current PAYE system is that a member may not initially get as much income as they were expecting due to an overpayment of income tax.

    When that happens, the next issue is when will they get their tax refund? It could vary from weeks to over a year. This, in turn, could cause cashflow issues and so it's critical the member has a realistic expectation of what initial income they will receive, and what they need to do to obtain a prompt refund of any overpaid tax.

    If we take a simple example, John is semi-retired and has income of £13,000 from working part time. He takes a one-off payment of £20,000 to pay for home improvements from his crystallised pension fund. As this will keep him well within the basic rate band, he expects to receive a net income of £16,000. However, as the pension provider had to apply an emergency tax code, he only gets £12,673.

    The overpayment of income tax of £3,327 could be refunded later by the pension provider if they're able to process PAYE refunds. If they can't, he could either make a claim in the tax year or wait until the end of the tax year to make the claim through his tax return. Alternatively, he could just wait on HMRC to make the calculation and pay the refund.

    The PAYE system, though under strain, has stood the test of time, but pension flexibility does highlight its weaknesses.

    With no immediate sign of the government taking steps to change the status quo, it's left to advisers to understand how the pension providers they use operate their PAYE system, and what steps can be taken to minimise the inconvenience to the clients, while also ensuring their clients' expectations are managed before they make any ad-hoc withdrawals.

    For support with tax year end, please take a look at our dedicated TYE hub.

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