Experts are raising the alarm about the pension tax system, and how savers could circumvent overpaying tax
Withdrawing a small amount from a pension can trigger a more reasonable taxcode than claiming large lumpsums(Image: GETTY)
People withdrawing money from their pensions are often taxed under emergency tax codes due to how the pension tax system works. However, this can leave people facing paying thousands of pounds more in tax than they should.
However, this money isn’t lost as it can be claimed back by HMRC in the form of a tax rebate. Savers may be able to avoid overpaying tax in the first place by being strategic with their first taxable pension withdrawals.
The first 25 per cent of your pension is paid out tax-free. After this HMRC applies a tax code at the highest rate you’re applicable for. This is where the £1 method comes in.
Clare Moffat, pensions expert at Royal London told the Telegraph: “How much you would need to take out would depend on your provider, so you need to check with them first.
“But even if you can’t take £1 out, taking out £100 may still be enough to generate a tax code from HMRC that the provider can apply.”
Once this tax code is generated, it’s still not guaranteed that HMRC will correctly calculate the applicable income tax on the pension income but the chance of needing a high value refund at the end of the tax year becomes a lot lower.
This happens because of the way HMRC calculates tax on pension income. It uses what’s known as a “month one” calculation method, looking at a person’s first month of income to calculate how much tax they might owe across the whole tax year.
The problem with this is that it means the tax authority also only applies one-twelfth of the person’s annual tax free allowances to the calculation, and people’s monthly income in retirement is often flexible.
The calculation can work if you regularly take out consistent sums from your pension. So the month one calculation can accurately reflect your income throughout the year.
However, if you take one large lump sum from your pension and then use that money for the whole year, HMRC assumes you’re getting this high amount every month and will tax you accordingly for the whole year.
Between April 1 and June 30 this year, HMRC refunded around £48.7 million during this time across nearly 13,000 refund forms. With the average person receiving £3,800.
If you do end up paying more tax on your pension income than you should have, there’s a number of ways get your refund.
The government’s website offers a free checker tool to see if you may be due refund and how best to go about claiming it.
In April this year, HMRC introduced some new processes to streamline this taxation dilemma by automatically updating tax codes for people who are new to receiving a private pension
However, since the change was introduced, the amount paid out in refunds has actually increased by more than £4 million compared to the three months from January to March 2025.