In this Tax Tip, we will explain the secret to understanding your latest tax code from HMRC. If your tax is paid under the Pay as you Earn method (PAYE) then it is up to you to make sure that it is working correctly. These days coding notices are produced automatically by HMRC’s computer and received by your employer or pension provider’s computer without any human intervention at all. This sometimes means that errors can go undetected for a whole year or even longer before anyone notices. HMRC will quite happily tell you that they may have made a mistake, but also that you should have noticed; a statement we feel should be challenged. But that is another story….
The first thing to do is check that you have received all of your coding notices, for HMRC issues a separate notice for each source of income that you receive. Then you need to check that they will actually take the correct tax. This is easy if you only have the one source of income but not quite so easy if you have more. Essentially, PAYE works like this. HMRC use the information they hold on you and your income to produce codes which they send to your employer/s and/or pension provider/s. They then use them to calculate what tax to take from your income and send it to HMRC. Probably the easiest way to explain it all is with some examples. (All use 2013/14 figures)
Take Mr Smith who is 57 and works at the local bakers, his only employment and source of income. He earns £16,000pa, paying all his tax under PAYE. He has a personal allowance of £9,440 on which no tax has to be paid and any income above that must be taxed at the relevant tax rate. HMRC should issue a tax code of 944L (by dividing his personal allowance by 10). When the employer receives the code they know not to pay tax on the first £9,440. His tax due will be £16,000 less £9,440 = £6560 multiplied by 20% making £1312 for the year.
Now imagine that Mr Smith is 66 (in the 2012/13 tax year) and still working at the local bakers, but also receiving a state pension of £7,500pa. Firstly, he will have a larger tax free personal allowance (PA) because he was born before 6th April 1948 meaning he is entitled to the age related allowance. He will have £10,500 but because he now receives the state pension, which cannot be taxed at source, this has to be deducted from his PA leaving less allowance than before to set against his earnings. £10,500 less £7,500 = £3,000 before tax is to be taken. His employer will now receive a code of 300P and they will take £2,600 in tax. (£13,000 at 20%)
Let’s take this a step further and imagine that he also has two private pensions, both starting in April 2013, of £1,800pa each. This brings his total income to £27,100 and which is over the £26,100 limit (known as the abatement level) for restricting the age related allowance (ARA). For every £2 over the limit, £1 is removed from the ARA until it is reduced to the personal age allowance of £9,440. Mr Smith is £1,000 over, so his tax free allowance will now be reduced by £500 to £10,000. His main code will now be £10,000 less £7,500 = £2,500 giving him a code of 250P on his employment. As all of his tax free allowance is used against his employment income, any other income must be taxed at 20% and for this reason both of his private pensions should be given the basic rate tax code of BR. The pension providers will know to take 20% of the pension. (£1,800x 20% = £360)
Next month – A few more examples and how to check that the tax taken is correct.