Tax  

Webb warns of pensions over-taxation in lockdown

Webb warns of pensions over-taxation in lockdown

Former pensions minister Steve Webb has called out HM Revenue & Customs on its pensions tax policy, warning Covid-19 and lockdown could lead to savers being hit by “draconian” tax penalties.

He warned HMRC’s tax policy on flexible withdrawals would hit savers harder during the coronavirus crisis as individuals look to take lump sums from their pots in order to make ends meet.

Under the pension freedom rules any withdrawals above the 25 per cent tax free amount are taxable at an individual's marginal rate of income tax.

In some cases, the pension provider will already have a proper tax code for the beneficiary, if the saver has previously withdrawn money from their pension during the tax year.

But where the provider does not have the correct tax code for the individual – which is in the majority of cases - withdrawals are taxed using a higher rate emergency tax code, which routinely results in an excessive tax deduction that has to be reclaimed later.

Analysis from consultancy LCP suggested the less an individual has in other taxable income, the more that individual will be over-taxed on withdrawal.

Given the current crisis, many people may have lost their jobs or are taking less income than normal, meaning far more people will have lower taxable income in 2020/21 than would normally be the case.  

Extent of over-taxation

Other taxable income during 2020/21

Actual tax deducted on pension withdrawal

(£40k pot of which £30k taxable)

Correct tax on pension withdrawalRefund due
£12,500£11,781£6,000£5,781
£25,000£11,781£7,000£4,781
£50,000£11,781£12,000[-£219]

Despite this HMRC will continue to deduct the same amount from pension pot withdrawals as they have always done.

Sir Steve, partner at LCP, said this means for many people pension withdrawals are set to get more penal in the midst of the current crisis. 

Mr Webb said: “It is already unacceptable that HMRC routinely over-taxes thousands of people on one-off withdrawals from their pension pots, leaving them to fill in forms to claw back the excess tax that they have paid.  

“But in the current crisis, this system will be even more penal. Lots of people who lose their jobs or suffer wage cuts will have reduced taxable income in 2020/21.  

“As a result, they should be paying less tax on these withdrawals. But HMRC is going to carry on taking exactly the same amount of tax upfront as it has always done. 

“This means that hard-pressed individuals will be over-taxed by more and will have to claim back more money – tax that they didn’t owe in the first place.”

Mr Webb has called upon HMRC to change the system, which he described as “far from ideal”.

He added: “The system of ‘emergency tax’ on one-off withdrawals from pension pots has already been widely criticised and it now looks unfit for purpose in the current crisis.  HMRC should think again as a matter of urgency”.

According to data published last month (April 30), HMRC paid back more than £33m in overpaid tax to individuals who withdrew money from their pensions during the first quarter of 2020.

This means the 2019/20 tax year was a record year for emergency tax applied to pension withdrawals, with HMRC repaying £166.6m in total.