In Tax Hacks, our columnist Mike Warburton – previously a tax director with accountants Grant Thornton – brings you his best tax-saving tips
This is the time of year that many of us in employment, or with private pensions, receive our first income with the new tax allowances incorporated into the 2019/20 PAYE coding notices.
Hopefully you will benefit from the increase in your take home pay resulting from the above-inflation increase in the basic personal allowance of £650 to £12,500.
This is worth about £10.80 a month for a basic-rate taxpayer and £21.60 for most higher-rate taxpayers. Sadly it is not always that simple. It all depends what else is lurking in your tax code.
The Pay As You Earn (PAYE) system was originally introduced in 1943. Tax rules were relatively simple back then and the system worked well. As successive chancellors have added more complications, PAYE has started to creak a bit, although recent upgrading of the HMRC computer systems have certainly helped.
For those with a single source of taxable income the PAYE system should collect the correct amount of tax without too many problems. With multiple income sources and higher-rate tax bands the system may collect too much or too little tax.
Each year HMRC carries out a reconciliation and makes the necessary adjustments with a tax repayment or note of an underpayment that can usually be collected with an adjustment to a tax code in a later year.
The key is to get the code as correct as possible. In my view this is a shared responsibility. HMRC can only issue codes based on information in its possession. It relies on both employers and employees to keep it informed of changes.
The basic rule is that your code is the amount of your personal allowance with the last digit removed, followed by a letter. Someone with a personal allowance of £12,500 with no other complicating factors will have a code 1250 L. This may also be the emergency code applied if you have started a new job and your employer has not received information on your previous employment.
A code BR means that tax will be collected at the basic rate of 20pc on all income. D0 means that all income will be taxed at 40pc and D1 is the code when 45pc applies. In Scotland the codes are SBR , SD0, and SD1 but with an additional SD2.
A code NT means that no tax will be deducted.
Now it becomes more complicated. If you have benefits, such as a company car or medical insurance paid for by your employer, this amount is deducted from your personal allowance before arriving at the code number.
If you make regular gift aid payments and are a higher-rate taxpayer, this will be added to your allowances and therefore your tax code, not by the amount of the payments but at a half of the payment plus 25pc.
Assume you make regular gift aid payments of £800. You add 25pc to make 1,000, divide by 2 to make 500 and then take off the last digit, meaning that 50 is added to your coding notice.
Where it can get really complicated is when someone has several income sources. Unfortunately this can often apply to those reaching pension age who may still be in full or part-time employment, receive a state pension and perhaps also a private pension.
This is where the PAYE system struggles because adjustments have to be made that may be larger than the personal allowance which effectively creates a negative tax code. These are called K codes. Take an example of someone with a state pension of £13,000 and a private pension of £10,000 who is still in employment. HMRC will probably issue the private pension with a BR coding and then calculate a K code required for the employment. In this example the state pension absorbs all the personal allowance so the code may just be K50.
However, if the combined income takes them into higher tax bands the K code will be increased by the amount needed to collect sufficient tax at the higher rate from the employment.
Without wishing to overcomplicate this, there are several other adjustments that can apply including those to collect underpaid tax from earlier years together with reductions in personal allowance for those with income over £100,000 a year.
For example, where an additional £800 is to be collected, the adjustment in the code number will be 400 for a basic-rate taxpayer and 200 for a higher-rate taxpayer, remembering that the code number is missing the last digit of the tax allowances applied.
One of the complications of PAYE is that it does not just collect income tax. The system also collects National Insurance Employee Contributions (NIC). These deductions can often be greater than the amount of income tax collected. Overall NIC is the second largest source of government revenue at about £138bn compared with £163bn in income tax collected under PAYE.
National Insurance was first introduced in 1912 as a contributory system to provide insurance against illness and unemployment. State pensions followed later. Over time, however, it has gradually become in many ways just another means of collecting tax on income.
When he became shadow chancellor, George Osborne considered whether the two systems could be combined and asked me to write a report on how this might be achieved. He repeated the exercise as chancellor.
What became clear is that, although performing a similar function, there were so many complications with differences in the respective rules that it was put into the too-difficult-for-now box. It was also politically sensitive. You only have to look at universal credit to see how a good idea in theory can become a nightmare in practice. For the time being we just have to accept that we have both systems and learn to live with them.
Mike Warburton was previously a tax director with accountants Grant Thornton.
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