HMRC repaid more than £25 million to savers in overpaid flexible pension tax in the last quarter of 2020, new government data shows. The amount repaid in Q4 2020 was £13.6 million less than in the previous quarter, and the third-lowest amount to be refunded in any quarter since the flexible pension began in 2015.
But experts still believe there is a "serious flaw" in the system, with HMRC being forced to repay nearly £700 million to savers since 2015. Over-taxation frequently happens with flexible pensions because the first withdrawal in any given year is given something called a 'Month 1' tax code.
Under this system, it is assumed that the first withdrawal of the year will be repeated throughout the other months.
As a result, the annual tax-free allowance, which is currently £12,500, is divided by 12 and applied equally to every month, starting from the first withdrawal date. This decision is based on an assumption by HMRC that all subsequent withdrawals that year will be for equal amounts and taken at regular monthly intervals.
The effect is for the tax-free threshold to sit at £1,042 per month, somewhat undermining the principle of flexibility attached to flexible pensions.
For example, if a saver's first withdrawal of the year was £3000, they might reasonably expect the transaction to be tax-free, as it is well below the £12,500 annual allowance.
However, the current system means that above £1,042, the standard tax rate of 20% would kick in.
Tax band thresholds are also divided by twelve under the system, meaning that 20% tax is automatically charged on withdrawals between £1042 - £3125 in any given month. Anything above this would be taxed at 40%.
This results in many people unknowingly surpassing their tax-free allowance and running up a tax bill for potentially thousands of pounds.
"This approach was painful before the pandemic hit but now risks adding extra financial hardship to those who are forced to dip into their retirement pot to make ends meet," said a senior analyst at AJ Bell, Tom Selby.
In the last three months of 2020, the number of people accessing their flexible pension increased by 10% on the same period during 2019. According to HMRC, the end of the year usually heralds a decline in the number of pensions withdrawals, and the unusual uptick could be a result of the COVID-19 pandemic.
We cannot discount the potential impact of COVID with more people having to access their pensions to either supplement their own income or help out family members who have been negatively affected, Depending on the life stages of those withdrawing money, there may be a looming black hole in the nation's pension savings.said Helen Morrissey, a pension specialist at Royal London.
From October - December, 360,000 people made a withdrawal on their flexible pension.
According to Selby, only a small number of those making their first withdrawal of the year take measures to avoid overblown tax bills further down the line:
Only those who fill out the official reclaim form will be repaid within 30 days by the Revenue. Those who don't will likely have to wait until the end of the tax year for HMRC to sort out their affairs, To give an idea of the scale, in 2020, around 38,000 official reclaim HMRC processed forms. In the same year, over 600,000 people flexibly accessed their retirement pot for the first time. While those who took a regular income should have had their tax code adjusted automatically, anyone who didn't will have been overtaxedhe said.
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