Why has drawing the state pension changed my tax code - and why wasn't I warned sooner? Steve Webb replies
In September, I reached 65 and was therefore entitled to take my state pension, which I am now receiving, even though I am still in full-time employment.
After that date I was informed by HMRC that my tax code had changed.
I get £6558.24 per year state pension or £126.12 per week. HMRC informed me that the full annual amount of pension I receive would be deducted from my annual tax allowance.
HMRC headquarters: Starting to draw a state pension can affect your tax arrangements
My allowance up to that date was 11,060, taking into consideration a small allowance for the cost of cleaning works uniform. I have since been informed that my allowance has now dropped to £4,502 which is a significant difference.
I have been studying pensions (state pensions, my civil service pension, as well as my private pension) for some time, particularly over the last two years (reading articles in the papers, online information as well as TV programmes), naturally because I am drawing closer to retirement.
Nowhere have I seen or heard of the annual tax allowance being affected by receipt of the state pension. After discussing it with colleagues at work (some close to retirement themselves), no one else is aware of it either.
Why does the tax code change? And why are people not informed until the eleventh hour? Is it assumed that everyone knows?
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Steve Webb replies: The key to understanding what has happened to you is to remember that most pensions are taxable.
In particular, the state pension, most occupational pensions and most private pensions are part of your taxable income, just in the same way that earned income is taxable.
If your total taxable income is below your personal tax allowance then no tax is payable. But if your earnings and pensions take you over the tax allowance then the excess is taxed, initially at the 20 per cent standard rate.
Steve Webb: Find out how to ask the former Pensions Minister a question about your retirement savings in the box below
For HM Revenue and Customs (HMRC), the issue is how they collect the tax that is due on pension income.
One option would simply be to ask the Department for Work and Pensions to deduct 20 per cent from your state pension at source. But this would be unfair on the millions of pensioners whose total income is too low to pay tax.
They would then have to claim back the tax which had been deducted. So instead, state pensions are generally paid before the deduction of tax.
A second option would be for HMRC to send every pensioner in the land an annual tax return on which they would list all of their taxable income and receive a tax bill.
This would, obviously, be hugely unwelcome and very inefficient given that around half of all pensioners have too little income to pay tax.
So instead, HMRC uses the system of tax codes to collect the tax due.
You have said that without your state pension, your personal tax allowance would be £11,060. This means that you can have £11,060 of taxable income each year without paying tax. But your state pension ‘eats up’ £6,558 of this allowance. This means that you can only have another £4502 of tax-free income before you start to pay tax.
What happens therefore is that HMRC tell your employer to ignore the first £4502 of earnings each year and then to apply income tax to the rest. In this way, you end up paying the right amount of tax over the course of the year, and you don’t have to fill in a tax return.
One thing you might want to think about if you have a good wage and are starting to pay tax at the higher rate (40 per cent) is the option of deferring your state pension, which you can do even if you have started to receive it.
The reason for this is that it is possible that part of your state pension is effectively being taxed at 40 per cent, because it is added on to your wages when your taxable income is calculated.
When you defer your pension you get an increase of 5.8 per cent for each year that you defer. One option would be to defer your state pension until you stop working and then draw a higher pension for the rest of your retirement. The point of this is that you would almost certainly only pay standard rate income tax on your state pension at this point.
You can find a lot of useful information about income tax rates and personal allowances on the Government's website here. This is relevant both to working and retired people.
However, HMRC is only likely to contact you and your employer about a tax code change when it is directly relevant to your current circumstances, as otherwise it would be constantly sending out a lot of general information to people who don’t need it.
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