More than a million people over 60 have had an unpleasant surprise from HM Revenue & Customs. They have been told it is changing the way their private pension is taxed. In theory the changes should make sure the tax deducted is more accurate. But the changeover has led to confusion and worry. And some people will be paying more tax than they have in the past.
The people affected have a pension they first paid into before 1 July 1988. These pensions are called Retirement Annuity Contracts (RACs or sometimes section 226 pensions) and were the forerunner of the personal pension which began that year. Generally they were paid into separately from work. But some people will have paid into one through their job if their employer was not large enough to run a full company pension scheme. Altogether there are about 1.2 million people drawing one of these pensions now.
In the past they were taxed in a very rough and ready way. Tax at the basic rate of 22% was deducted automatically before the pension was paid. People who had no tax to pay could declare they were a non-taxpayer on a form called R89. That would ensure that the pension was paid in full without tax being deducted. Many people did not do that. And anyone who should have paid tax on only part of the RAC pension or paid tax at the lower rate should have reclaimed some of the tax deducted automatically. Unfortunately around 200,000 non-taxpayers never did that and have paid too much tax from the day they retired. They should now claim back the tax that has been wrongly deducted. Unfortunately Revenue rules mean overpaid tax can only be reclaimed back to 2001/02.
From April this system has changed and people on these RACs will be taxed like those on a company or personal pension through a tax code. The code tells the pension provider how much tax, if any, to deduct and should be more accurate than the rough and ready system of deducting 22% off everyone. But the system of issuing those codes has been the subject of many complaints with non-taxpayers being forced to pay tax on the whole pension. The new system has been so confusing that helplines have been overloaded.
Each year people are allowed a certain amount of income before tax is due. From April that amount is £5225 for people under 65, £7550 for those aged 65 to 74 and £7690 for anyone who is more than 75. If your total income from all sources including your state pension and your RAC is less than this amount then you should pay no tax on your RAC.
Tax codes are a way of collecting tax not of assessing it. For people on basic rate tax or who pay no tax they are usually accurate. But for people on lower or higher rates of tax, who have other irregular income, who earn interest on their savings, who reach 65 or 75, or who get married couples allowance the tax code can cause the wrong amount of tax to be deducted.
Tax codes work like this. It starts with your personal allowance. Say that is £7550. From that is deducted your state pension. This is paid gross without tax being deducted so it uses up a chunk of your tax-free income. Say that is £112 or £5824 a year. £7550 - £5824 = £1726. So £1726 is the amount of income you can have on top of your state pension before tax is due. Your tax code is the first three digits of this amount, 172, and is used by your pension payer to work out how much tax to deduct. There is also a letter after those three digits which does not normally affect the amount of tax. These letters follow the three digits.
L – you have the basic personal allowance of £5225
P – you have the age 65-74 age allowance of £7550
Y – you have the age 75 or more allowance of £7690
V – age allowance and married couple’s allowance both partners aged 65-74
T – none of the above or you have asked HMRC to keep that information private
So the full code in the example above would be 172P.
As well as the state pension, other sources of income such as interest paid gross can be deducted from your allowance before the code is worked out.
For some people the state pension may be more than their tax-free allowance. In that case they get a K code. The K goes before the three digits and a private pension or any earnings will be taxed at a higher rate to make sure that the tax due on the state pension is collected from that. Other codes you may see are BR or D0. They normally apply to a second pension or job and mean that all this income is taxed at basic or higher rate as all your allowances have been used up with the first pension or job. You may also see NT which means no tax is to be deducted.
April 2007