Elaine Turtle: Retirement income tax confusion remains

Elaine Turtle looks at the confusing interaction between the personal allowance, an individual's tax code and the way income tax is calculated on monthly income

Benjamin Franklin is credited with saying “in this world, nothing can be said to be certain, except death and taxes.”

However, while taxes may indeed be certain under the UK taxation system, it continues to provide a great deal of confusion.

An example of this relates to the application and relationship of the personal allowance with an individual’s tax coding and the calculation of income tax on income received from month to month. This is very important and highly misunderstood.

Who hasn’t heard clients say, ‘But my personal allowance is nearly £12,000, I should get everything tax free!’

Most people who have one job or pension will have a tax code of 1185L. The number in the code confirms how much personal allowance an individual has while the letter confirms how the personal allowance might be applied. In this example, the personal allowance is £11,850 and ‘L’ signifies entitlement to the personal allowance amount. For more information on coding, see https://www.gov.uk/tax-codes

What people forget of course is that the tax coding applies across the whole of the tax year unless a new coding notice is received. The income tax system is, in essence, a cumulative tax system whereby allowances are accrued month to month rather than being given in full at the start of the tax year.

And herein lies the rub. Individuals expect to receive income payments, tax-free, up to their personal allowance and then start paying tax.

This will often mean that when they receive a payment below the personal allowance, they will be concerned and confused that tax has been deducted. What they forget is that allowances will still be applied and offset against income received, but across the whole of the tax year. For example:

Calculation Tax allowance
Personal allowance applied in month 1 £11,850 / 12 £987.50
Cumulative personal allowance applied in month 2 £11,850 / 12 x 2 £1,975.00
Cumulative personal allowance applied in month 3 £11,850 / 12 x 3 £2,962.50
Cumulative personal allowance applied in month 6 £11,850 / 12 x 6 £5,925.00
Cumulative personal allowance applied in month 9 £11,850 / 12 x 9 £8,887.50
Cumulative personal allowance applied in month 11 £11,850 / 12 x 11 £10,862.50
Cumulative personal allowance applied in month 12 £11,850 / 12 x 12 £11,850.00

 

The flip side of this is that the way HM Revenue & Customs administer the system makes an assumption that £11,850 is being paid each and every single month of the tax year, equivalent to an annual income of £142,200.

So, reverting back to our original example of the client who is looking to receive £11,850 in April on the assumption this equals the personal allowance and is, therefore, tax-free. They will only receive 1/12th of the personal allowance and then 1/12th of the 20% tax band and so on, so their net payment would look something like this:

Income paid: £11,850.00
Personal allowance (tax-free pay): £11,850 x 1/12 £987.50
20% tax threshold: (£46,350 – £11,850) x 1/12 £2,875.00
Balance of income subject to 40% tax: £11,850 – £987.50 – £2,875 £7,987.50
Tax calculation: £2,875 x 20% (£575) + £7,987.50 x 40% (£3,195) £3,770.00
Net income received: £11,850 – £3,770 £8,080.00
Shortfall in income expectation: £3,770.00
Effective rate of tax: £3,770 / £11,850 31.81%

 

As you can see the client is left with a shortfall in expected income and an arduous process of seeking to recover the tax from HMRC.

They could wait until the end of the tax year but more often than not completing HMRC form P55 will obtain the refund sooner.

However, what may ultimately be the best solution is for the client to re-structure their income pattern, they can either take an annual payment at month 12 – so end of March and as this is the end of the tax year, they don’t have the issue with HMRC thinking they will be having the annual amount monthly.

Alternatively, they could spread the payments evenly across the tax year. The desired outcome is that the client will still withdraw £11,850 over 12 months from their pension scheme but each payment will be free from income tax.

Elaine Turtle is director at DP Pensions

PAYE tax rates and thresholds 2018 to 2019
Employee personal allowance £228 per week
£988 per month
£11,850 per year
UK basic tax rate 20% on annual earnings above the PAYE tax threshold and up to £34,500
UK higher tax rate 40% on annual earnings from £34,501 to £150,000
UK additional tax rate 45% on annual earnings above £150,000

 

Scotland

PAYE tax rates and thresholds 2018 to 2019
Employee personal allowance £228 per week
£988 per month
£11,850 per year
Scottish starter tax rate 19% on annual earnings above the PAYE tax threshold and up to £2,000
Scottish basic tax rate 20% on annual earnings from £2,001 to £12,150
Scottish intermediate tax rate 21% on annual earnings from £12,151 to £31,580
Scottish higher tax rate 41% on annual earnings from £31,581 to £150,000
Scottish top tax rate 46% on annual earnings above £150,000