By James Jones-Tinsley, Self-Invested Pensions Technical Specialist at Barnett Waddingham
Last year, I wrote about the chronic situation regarding the overpayment of income tax on initial payments of pension income from DC pension arrangements.
I wonder if somebody within HM Revenue and Customs (HMRC) read my blog, because – as we enter a new tax year – HMRC is finally addressing the long-standing issue of pension tax overpayments.
For years, individuals withdrawing pension income from their DC pension arrangements have faced excessive taxation, due to the imposition of emergency tax codes. The government now plans to change how tax codes are applied to these withdrawals, with the aim of reducing the burden on pensioners, as well as streamlining tax processes.
A long-standing issue, partially resolved
Since the introduction of the so-called ‘pension freedoms’ 10 years ago, first-time withdrawals from DC pensions have been subject to emergency tax codes. This has forced individuals to reclaim overpaid taxes from HMRC, creating a complicated and often frustrating process.
"We will automatically update the tax code for customers who are on a temporary tax code and would benefit from being on a cumulative code — this means they’ll avoid an overpayment or underpayment at the end of the tax year."
HMRC
Data indicates that approximately 470,000 claims have been made, totalling an unbelievable £1.4 billion in overtaxed pensions since 2015.
From this month onwards, HMRC will update tax codes more efficiently to ensure pensioners are on the correct tax code as quickly as possible. A statement from HMRC reads: "From April 2025, we are improving how tax code information is used for those people who are new to receiving a private pension, so they pay the right amount of tax. We will automatically update the tax code for customers who are on a temporary tax code and would benefit from being on a cumulative code — this means they’ll avoid an overpayment or underpayment at the end of the tax year."
This move is thankfully expected to reduce the number of individuals who need to claim back excess tax payments. However, questions remain about whether the change is as beneficial as it seems.
Industry reactions: progress, but not perfection
"For too long, hundreds of thousands of people have been overtaxed and had to jump through hoops to claim back their own money."
Steve Webb
Former Pensions Minister
While the pensions industry has largely welcomed this change, there are concerns that the reform does not go far enough. Steve Webb, a former pensions minister, has long campaigned for improvements in this area. He described the change as "great news" and praised HMRC for "finally listening to the voices of ordinary taxpayers."
He added: "For too long, hundreds of thousands of people have been overtaxed and had to jump through hoops to claim back their own money. This new system should mean that far more people are quickly moved onto the correct tax code and no longer end up with an overpayment of tax. The tax system is complex enough as it is, and this change should hopefully reduce the complications pension savers face when they try to access their hard-earned cash."
The limitations of the new system
Despite this, experts argue that the reform does not fully address the core issue. Most notably, HMRC’s new approach does not eliminate the application of emergency tax codes to initial pension withdrawals. Instead, HMRC will simply issue the correct tax code more quickly than before, meaning that excess tax deductions may still occur before adjustments are made.
"HMRC's new initiative to improve tax codes is undoubtedly a positive development, but its impact will be limited."
James Jones-Tinsley
Self-Invested Pensions Technical Specialist, BW
Therefore, while this change may benefit those who choose to receive regular monthly pension payments, it will not significantly help those taking lump sum withdrawals at outset. This is because HMRC has confirmed that "the rules for taxing first pension payments are not changing as part of [these improvements] and the normal rules of Pay-As-You-Earn (PAYE) will continue to apply."
In practical terms, this means that:
Emergency tax codes may still be applied to first-time withdrawals, leading to excessive taxation.
Those withdrawing their full pension pot in one go, via an Uncrystallised Funds Pension Lump Sum (UFPLS), will still face immediate tax deductions that may be too high.
Payments made at the end of the tax year may not benefit from the improved coding system in time.
In conclusion, while HMRC’s new approach is expected to streamline the tax code process overall and reduce the number of individuals needing to reclaim overpaid tax, it does not eliminate the issue entirely. The reliance on emergency tax codes for first-time withdrawals will persist, meaning that many individuals will still experience an initial over-taxation before their codes are corrected.
For those taking monthly pension payments, this change should lead to a faster correction process, ultimately ensuring that the correct amount of tax is deducted sooner. However, those taking one-off lump sums will still need to navigate the complex and sometimes frustrating tax reclaim system.
In comparison with the situation that I vented my spleen about last year, HMRC's new initiative to improve tax codes for individuals is undoubtedly a positive development, but its impact will be limited. The pensions industry will be watching closely to see whether these changes genuinely reduce over-taxation or simply speed up the existing reclaim process. For the time being, individuals must remain vigilant and be prepared to navigate the tax system if they find themselves overtaxed on their pension income withdrawals.
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