During my working life, I have only ever had a single income stream, so tax has just been simple(ish) PAYE.

However, that is about to change. I currently get an income from a defined benefit pension, then next year I will also get the state pension, then I will also start drawing-down income from my SIPP. I’ve already taken all the tax-free lump sums.

How can PAYE handle this? Do I get a tax code for a third of the £12,570 personal allowance for each pension? Or do I get different tax codes for each pension? Or does the taxman just guess, then correct it with tax deductions every year in arrears?

I’d really like to set it up so it’s just correct!

Thanks,

Tim

Rachel Vahey,  AJ Bell Head of Public Policy, says:

When someone is receiving income from several different sources, paying tax can get quite complicated.

Let’s start off with the basics. Your pension provider will usually take off any tax you owe before they pay you under the PAYE system – so your income is paid net. State pension, however, is paid gross. But the tax code HMRC gives your pension provider takes into account your state pension. For someone on full state pension of about £11,500 this uses up most of their personal allowance, so only about £1,070 is left for other incomes.

When you start to receive a pension for the first time, HMRC is not able to work out your tax code until it has received some information from either you or your pension provider. You may have a P45 form to hand to your pension provider if, for example, you have just stopped working and immediately afterwards start to take a pension.

But if you do not have a P45 form to hand, your pension provider will send details of your new pension direct to HMRC via the electronic PAYE system, to make sure they are making the correct deductions.

At the end of the tax year, you’ll get a P60 from your pension provider showing how much tax you’ve paid. You should get this by 31 May. This shows the total amount paid in the tax year, the tax deducted and the final tax code in operation.

EACH PENSION WILL NEED A TAX CODE

If your income only comes from one private pension source, then you’ll usually have one tax code. But if you have more than one private pension being paid – be it from an occupational or personal pension – then each pension (other than the state pension) will need its own tax code.

Usually, the first pension you start will have a tax code that reflects any remaining personal allowance after state pension (in your case the defined benefit scheme tax code will change once your state pension starts). The tax code for a second private pension usually means all that income is taxed at one rate, with no personal allowance as it’s already been used elsewhere. Whether this is all at basic rate or all at higher or additional rate will depend on the income taken from the first pension. This isn’t perfect so corrections may need to be made at the end of the tax year.

Although you will have a separate code for each source, you should just get a single coding notice for all your sources of income that are taxed under PAYE. Pensioners may get coding notices more often than employees – for example, if you start to draw a new source of pension income to which PAYE is applied for the first time you will get a new single coding notice.

You need to make sure that you are not getting too many or too few allowances by looking at all of your tax codes for a tax year together – these should all be shown on the same PAYE coding notice.

EMERGENCY TAX RISK

There is one more thing to be aware of. If you take taxed income out of your drawdown pension, then you may initially be taxed on emergency tax rates.

The problem can affect anyone who takes a taxable pension freedoms payment from age 55 – either through drawdown or through an ‘Uncrystallised Funds Pension Lump Sum’ (UFPLS) withdrawal. Where the pension saver cannot provide a current year tax code, HMRC requires their pension provider to use either an emergency tax code on a ‘Month 1’ basis, or if they have a current year P45 this is applied on the same basis.

This means HMRC only gives them 1/12th of the usual tax allowances available on the withdrawal. If only one payment is taken in the tax year this results in many savers being severely overtaxed. If regular income is taken, although the first payment may be overtaxed this is usually corrected by the tax code used for subsequent payments in the tax year. (A current year tax code is usually only supplied by HMRC after the first payment is made.) 

Pension savers can, however, take action to get their money back quickly, hopefully within 30 days, by filling out one of three reclaim forms, which differ depending on whether you took all or only some of your pension pot and whether you’re still working.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to askrachel@ajbell.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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