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Coding error

28 June 2017

Among the many who have taken advantage of pension freedoms, 800,000 could be paying the wrong amount of tax on withdrawals.

Three years ago George Osborne, the then chancellor, unveiled an unprecedented package of pension reforms. The changes meant that individuals aged 55 and over could henceforth access their defined contribution pension savings whenever they wanted and in a variety of ways, subject to their marginal rate of Income Tax. 

Hundreds of thousands of people have since taken advantage of these reforms. In total, over 1.5 million separate payments have been made, with £9.2 billion withdrawn since April 2015. In the final three months of 2016 alone, 162,000 people accessed £1.6 billion from their pension pots.

Root cause

But despite being able to take benefits in a variety of different ways, including as cash and flexible income, vast swathes of individuals are at risk of paying too much tax on their pension income. 

Nearly 30 million people in the UK pay Income Tax. Around 10 million file tax returns, while the remaining 20 million are taxed on the ‘pay-as-you-earn’ system2, which is built around tax code allocation and designed to collect the right amount of tax from everyone over the course of the year. But if tax codes are incorrect, then it follows that the wrong amount will be collected.

Because many over-55s have multiple sources of taxable income, such as a salary and one or more pensions, it is believed that 800,000 could be at risk of being allocated the wrong tax codes2

The answer lies in the way HMRC applies the ‘personal allowance’ when you have more than one source of income. Your ‘personal allowance’ is the amount you can earn tax-free and, in some cases, HMRC applies it only to income from one source; for example, a part-time job. HMRC then taxes other sources of income, such as a personal pension, at the full rate. 

This means that even if your total income is below the personal allowance of £11,500, HMRC assumes you have already used your allowance for one income source and disregards it for other sources.

Tax take 

Individuals are being urged to check their tax code to ensure that they are paying the correct amount, and to apply for a refund if they have been over-taxed. In some cases, overpayment of tax could have been going on for many years – so some diligence is needed.

“Most people are understandably baffled by the whole system of tax codes,” says Steve Webb, director of policy at Royal London. “Employers and pension providers are issued with tax codes by HMRC and we generally assume they must be right.”

However, HMRC is not infallible, and Webb highlights the importance of individuals knowing how to spot mistakes with their tax code and to get things put right. “Although computerisation of tax records is designed to help improve things, I have no doubt there are many people still paying the wrong amount of tax.” 

Paddy Millard MBE, founder of the charity Tax Help for Older People, shares some of Webb’s concerns.

“Tax codes are probably one of the biggest single causes of confusion and problems among the people who contact us via our helpline,” he says. “People should not simply assume that HMRC have got things right, but should check to ensure they are paying the right amount of tax.”

HMRC certainly believes its record is strong in this area, as a spokesman for the department recently made clear: “The overwhelming majority of tax codes are accurate, based on information provided to us.”

Nevertheless, it is crucial you check your tax codes to ensure you are paying only what is due, as mistakes are far from impossible.

If you have a Government Gateway account, you can check you are paying the right amount of tax using HMRC’s online service. Alternatively, you can write to them, or phone on 0300 200 3300.

1 HM Treasury, January 2017
2 Royal London, April 2017

 

 

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