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I turned 66 earlier this month. I received my pension letter to confirm that I receive a state pension of £203 per week, a lower amount due to factors relating to my private pension.
How will the two pensions be taxed and how is my tax code calculated?
Do my savings accounts and the interest earned have anything to do with the tax code I am given?
I took early retirement several years ago, drawing my private pension, which is below the annual tax threshold, but that will change when I also receive the state pension.
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Financial Planning: How will my state and private pensions be taxed and how is my tax code calculated?
Steve Webb answers: As things stand, his company pension and other taxable income are below the personal tax-free limit of £12,570.
This means that your private pension provider is paying your pension without deducting any income tax.
As you may have noticed, once you start receiving your state pension, this will change.
Although state pensions are considered taxable income, they are always paid on a gross basis, i.e. without deduction of any income tax.
However, as you say, when you add your state pension of more than £10,000 a year to your private pension, this takes you over the tax threshold and you start to become a taxpayer of income tax.
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The good news is that the Pay As You Earn (PAYE) system should kick in and ensure the correct amount of tax is collected throughout the year without any further action required on your part.
What happens is that DWP (who pay your state pension) will notify HMRC how much they are paying you in state pension.
HMRC will be aware of your private pension from the information provided by your pension provider and will be able to see that you are now a contributor.
HMRC should then issue a new ‘tax code’ to your private pension provider requiring them to start deducting income tax before your private pension is paid.
One consequence of this is that once your state pension is paid out, you will see a cut in the amount of private pension you receive in your bank account.
The tax code is set up in such a way that, if everything runs smoothly, at the end of the tax year the total amount of tax deducted by your private pension provider should match the amount of tax owed on your total income from your state pension and private pension combined.
Turning now to any taxable income you have from savings or investments, I’ve written in more detail about how this is taxed here: Do Rising Interest Rates Mean More People Have to File Taxes?
However, the key points that are relevant to your situation are:
– You have a ‘personal savings allowance’ – as a basic rate taxpayer this is £1,000 a year – as long as your interest income etc is below this figure, this is all tax free;
– You also have something called a “starting rate” of tax on savings, which is 0 per cent – if your combined income from your state and private pension is less than £5,000 above the tax threshold (in other words, less than £17,570 this year), then any excess up to that figure can be deducted from your remaining taxable income from savings – for example, if your state and private pension total £15,750, you can have another £2,000 of interest income that is tax-free;
– If your savings income comes from dividends (held outside individual accounts etc.) then there is an additional £500 per year tax-free allowance. There is also a special lower rate of tax on dividends for taxpayers on a basic rate of 8.75 per cent.
As with your private pension, your bank or building society will usually report your interest income directly to HMRC.
If any of this exceeds your allowances as described above, this will also be taken into account in your tax code so that the correct total amount of tax is paid.
In summary, for most people with relatively simple tax affairs in retirement, such as a state pension, a private pension and some modest interest income, the correct amount of tax should be deducted automatically without any further action required on your part.
However, if you have other income that HMRC is not aware of, such as rental income from a property, then you will need to declare this by completing a self-assessment tax return so that the correct amount of tax can be collected.
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