An advisory body to the Treasury has called for a review of the rules under which thousands of saves are taxed at emergency rates when drawing down their pensions early.

Since the pension freedoms came into force in 2015, hundreds of thousands of over-55’s have taken advantage of new flexibility to withdraw lump sums from their retirement pots at their own will.

However, those savers that do not have an up-to-date tax code have seen the lump sums taxed at an “emergency tax” rate, resulting in a much larger portion of their pension be legible to tax. In order to claim the money back, savers have to complete an application form.

In a report published on Friday by the Office of Tax Simplification (OTS), the adviser said the use of emergency tax code for pension lump sum withdrawals should be reviewed and that “more could be done” to help people understand the tax implications of pension withdrawals.

“The OTS would like to explore this further with HMRC, in addition to working to identify options other than initial tax deduction using emergency tax codes on personal pensions, which generally results in the deduction of too much tax when the payment is made,” the OTS said in its report.

AJ Bell head of technical resources Gareth James said: “The approach to taxation of pension freedom withdrawals is loaded in favour of HMRC. Hundreds of thousands of people will have received a lower amount after tax than they were expecting because of the extra tax deducted from their payments. Whilst this can be reclaimed, the fact is lots of people will not be aware that they need to do this.

AJ Bell recently found that 63 per cent of people that have used the pension freedoms assumed they had been taxed correctly on their first withdrawal, with a further 24 per cent stating that they did not know whether or not they had been taxed correctly.

“The recommendation from the OTS for HMRC to review this process is very welcome. A change is long overdue given that pension freedoms have now been in existence for over three years and HMRC have been going digital for a similar length of time. Given the investment in making PAYE reporting real time and the introduction of dynamic coding, a solution that suits all parties could be achievable,” James said.

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