Seven years on since pensions freedoms were introduced we still have ongoing issues with over taxation of ad hoc pension payments made under the 'new' rules.
These are not insignificant amounts. In the latest Pension Schemes newsletter (July 2022) the total value of repayments HMRC made to those that had overpaid tax from April 1 2022 to June 30 2022 was £33,689,819 from just over 10,000 reclaims.
In total, since April 2015 HMRC have processed more than 330,000 reclaim forms and repaid close to £900mn. The magic £1bn mark will likely be reached in the next 12 months – and the trend is for the quarterly reclaims to keep getting higher.
These numbers illustrate this is a substantial issue that leads to a large number of people every year paying too much tax on their pension income and later having to recover it. This can cause disruption, make it more difficult to plan and is a considerable time and effort burden for both the individual and HMRC.
And this is not even the whole picture when it comes to overpayment of tax. These are only the figures for those that take the time to complete the paperwork for the in-year reclaims.
There will be many who are happy to wait for the P800 calculation, either because they have smaller reclaims or their payments are due near the end of the tax year. And, of course, some will simply not realise they have overpaid tax at all.
So, why does this issue arise and how do you get the overpayment back?
How is PAYE applied when someone takes benefits?
Since April 6 2015 it has been possible to take uncrystallised funds pension lump sums (UFPLS) and flexi-access drawdown payments from defined contribution pension schemes.
These payments are subject to income tax and HMRC has set out to pension scheme administrators how tax codes must be applied under PAYE.
When the member can provide the administrator with a current year tax code then this can be used and applied on a cumulative basis. In practice this often only happens when the member is taking a regular income as the current year code is supplied after the first payment is made.
If the member retires from employment and then starts taking benefits they may have a P45 valid in the current tax year, if this is the case this can be used but must be on a 'month one' basis. If the member has no current year tax code or P45 then an emergency tax code will be used, also on a month one basis.
What does 'month one' mean?
When a payment is made on the month one basis, the member will be taxed on that pay period only. Effectively this means that each month is treated discretely, with a twelfth of the personal allowance and each tax band applying.
This is opposed to a 'month 12' basis where the full annual personal allowance and tax bands are available. When a one-off or annual payment is made ideally a month 12 basis would be used but HMRC rules do not permit this in relation to flexible pension payments such as UFPLS and flexi-access drawdown.
