According to HM Revenue & Customs, tax doesn’t have to be taxing. But try telling that to anyone who has retired recently and taken advantage of their new pension freedoms.
Retirement used to be simple. On your 65th birthday you cleared your desk, thanked your boss for the carriage clock and went home to await the monthly pension cheque. Things are rather more complicated these days.
With an average of 11 employers over a working lifetime and the growing popularity of phased retirement, it is increasingly common for pensioners to have multiple sources of income. And pension freedoms mean practically unlimited flexibility in how that income can be taken.
On the face of it, this sounds fine. Pensions are usually paid through PAYE so pensioners do not have to worry about complicated tax returns. Most administrators use an off-the-shelf third-party payroll or administration system to manage tax records and tax outgoing payments. In the past, this generally worked quite well.
However, most of those payroll systems were originally designed for paying employees, typically on a monthly basis, driven by traditional business and tax cycles. They struggle to cope with the practicalities of irregular, ad-hoc payments and do not cater well for multiple accounts or drawdown arrangements making payments to the same pensioner.
Add to all this the fact HMRC guidance is confusing at best and often seemingly contradictory and we are left with a bit of a mess.
The result of this is that payments can often be under or over taxed and regularly misreported to HMRC.
This leaves pensioners putting their trust in their administrator, but ultimately could end up either exposed to tax bills they are not expecting, or not receiving the benefits they are entitled to and having to reclaim overpaid tax.
As an example, if a pensioner today decided to take some of their pension into drawdown and take a quarterly payment, a traditional payroll system would likely manage their tax record on a monthly payment basis. If they were paid in the first month of each quarter in the tax year, they would miss out on two months of tax allowance on each payment they received.
On a quarterly payment of £3,000, this would see them lose tax allowance on roughly £2,000. As a basic rate tax payer, this could mean they were underpaid by around £500.
You would get the missed allowance from Q1 back in Q2, but lose it again from Q2 and so on. Unlike a normal monthly PAYE payment, it would not work itself out so they would end the year nearly £500 down in overpaid tax and have to reclaim it or wait for the following year’s tax code to get it back. But then, of course, they would still be overtaxed next year too.
Worryingly, some administrators don’t seem to be aware of the problems or even some of the regulation itself. Even worse, HMRC knows it’s going on but is not doing much about it.
In fact, the whole approach to pension payments and PAYE seems like a throwback to a different era. It is about time financial services caught up with the on-demand, instant response world the rest of society is already living in.
Kevin Okell is managing director at Altus