Pensioners and car finance compensation tax

Many pensioners can get back all or most of the tax taken off their car finance compensation. Lenders deduct basic-rate tax from the interest part of every payout, without knowing anything about your income. If you’re retired on a modest income, the interest is often covered by your tax-free allowances, so that tax wasn’t owed.

How pensions are taxed

The State Pension counts as taxable income, but it is paid without any tax taken off. You only pay tax if your total taxable income, including the State Pension, is more than your Personal Allowance (GOV.UK). Private and workplace pension providers usually take off any tax due before they pay you, through your tax code (GOV.UK).

The full new State Pension is £241.30 a week for 2026/27, and the full basic State Pension is £184.90 a week (DWP). Over a year, the full new State Pension comes to £12,547.60, just under the £12,570 Personal Allowance. The rate for 2027/28 hasn’t been confirmed yet.

Why the interest is often tax-free

The interest in car finance compensation is savings income. Three allowances can cover it (GOV.UK):

• any unused Personal Allowance
• the starting rate for savings: up to £5,000 of interest at 0% if your other income is under £17,570, reduced by £1 for every £1 of other income above £12,570
• the Personal Savings Allowance: £1,000 for basic-rate taxpayers

For a pensioner whose only income is the full new State Pension, that adds up to about £6,000 of interest tax-free in a year. Our guide to the starting rate for savings explains how the band works.

Examples for the 2027/28 tax year

Both examples use compensation with £1,240.60 of interest, from which the lender deducted 22%, which is £272.93. They assume the person has no other savings interest, and that the State Pension is £12,547.60, the 2026/27 rate (2027/28 rates aren’t set yet).

	State Pension only, plus a £4,000 workplace pension	State Pension plus a £12,000 workplace pension
Income apart from savings	£16,547.60	£24,547.60
Starting rate band left	£1,022.40	£0
Personal Savings Allowance	£1,000	£1,000
Interest that is tax-free	All £1,240.60	£1,000
Tax actually due on the interest	£0	£52.93
Tax to reclaim	£272.93	£220.00

In the second example, £240.60 of interest is above the allowances and is taxed at 22%. The rest of what the lender deducted is still owed back.

Simple Assessment and the State Pension

If HMRC can’t collect tax through a tax code, for example because your only income is the State Pension, it may send a Simple Assessment bill after the end of the tax year (GOV.UK). In its Budget of November 2025, the government said people only receiving the basic or new State Pension would not have to pay small amounts of tax through Simple Assessment from April 2027 (GOV.UK). That is about tax on the State Pension. It doesn’t stop lenders deducting tax from compensation interest, so reclaiming that tax still needs a claim.

Tax-free benefits don’t count

Pension Credit and Attendance Allowance are tax-free, so they don’t count as income when working out your allowances. Only taxable income, such as the State Pension and private pensions, does.

Getting the tax back

The tax is reclaimed from HMRC with form R40, separately for each tax year. You can also claim from HMRC yourself. If you claim with us, we work out your allowances from your pension income, prepare the claim and submit it as your agent. Our rebate calculator gives a quick estimate, and our guide to reading your compensation letter shows which figures you’ll need.