LITRG Suggests State Pensions Have Own PAYE System

Most employees (and perhaps many pensioners) will be aware that they are paid under the Pay As You Earn (PAYE) system.  PAYE is a system where employers and pension income providers pay income to employees and pensioners via a payroll system where income taxes and national insurance contributions are deducted from gross pay.

HMRC Sends Tax Codes to Employers and Pension Payers e.g., 1257L.

• The number 1257 when multiplied by 10 is the amount of personal tax allowance, e.g.  £12,570, i.e., the amount you can be paid tax free before income taxes start to be applied.  The personal tax allowance is spread across the tax year. 
• This means if you have a code of 1257, your personal tax allowance of £12,570 is applied each month at £1,047.50 and any income for that month above this then has income taxes deducted.
• The letters in a tax code, can vary and have different meanings. 
• E.g., For 1257L, the L means income taxes are to be deducted at basic, higher and additional rates of tax.
• E.g., For 1257M, the M means income taxes are also to be deducted at basic, higher and additional rates of tax but the individual has had some (up to 10%) of their spouse/civil partner's unused personal tax allowance to transferred to them.  The spouse/civil partner will also have the letter N in their tax code to indicate they have given up some of their allowance.
• E.g., For 1257S, the S means taxes are to be deducted at Scottish rates of income tax.
• E.g., Tax Code NT (with no numbers) means No Taxes are to be deducted at all.  We see this regularly for expats living overseas that have UK pension income paid to them but the UK tax treaty with the relevant country of residence means income taxes should be paid where you live and not in the UK.
• E.g., Tax Code BR (with no numbers) means all income is taxed at basic rate with no personal allowance e.g., if you have a second job and your first job is using all your personal allowance.
• For more on Tax Codes, see https://www.gov.uk/employee-tax-codes/letters

State Pensions and Frozen Personal Allowance

State pensions are paid gross without any deduction of income taxes.

• The personal tax allowance has been frozen at £12,570 for several years and increasingly more and more pensioners are paying income taxes as our incomes rise and the allowance has not.
• Paying income taxes on private and company pension income is not a problem as HMRC issues a Tax Code to them.  That said there can still be problems where pensioners have others sources of income e.g., interest, dividends, rental income, that have been paid without tax deduction meaning a tax bill at the end of the year.

State pensions are starting to become a ‘headache’ now.  Many pensioners still have the old-style ‘Old Age’ Basic State Pension and ‘Additional’ State Pensions from the now defunct State Earnings Related Pension Scheme (SERPS) and State Second Pension (S2P) rather than the New State Pension (started in 2016).  Put simply, there are two types of state pension scheme route.

For more, see 2 Types of State Pension

In many cases, the Old Age/Basic State Pension plus Additional State Pension, are higher than the Personal Allowance (£12,570) meaning that income tax is due but has not been deducted as state pensions are paid gross.  This means that many pensioners owe tax and at the end of the year they get an unexpected tax bill to pay.

‘New’ State Pension problem on the horizon. 

• For tax year 2025/26, the new state pension is £230.25 per week (£11,973 pa) and for tax year 2026/27 it will be £241.25 per week (£12,545 pa). 
• This is only just below the personal allowance of £12,575 meaning many more pensioners with private/company pension income or interest/dividends/rental income may now fall into the income tax trap and face tax bills at the end of the year.
• For tax year 2027/28, when the new state pension increases yet again, without action, the state pension will be above the personal tax allowance meaning most pensioners will get tax bills at the end of the year and be required to pay some of their state pension back in income taxes.
• This would be an administrative ‘disaster’ for HMRC.

To try and counter the upcoming tax bills and administrative problems for pensioners (and HMRC alike), the Low Incomes Tax Reform Group (LITRG) has called on the Treasury to make it easier for state pensioners to pay any tax they owe by establishing a PAYE system for state pensions, similar to that used by employers and pension income providers.

See https://www.litrg.org.uk/press-release/litrg-give-state-pension-its-own-paye-scheme

Comment

We suggest a State Pension PAYE system makes perfect sense and would make payment and collection of income taxes so much easier for all and bring it into line with employee PAYE.

This may take some time be costly to set up, so we have suggested in the past and we do so again that perhaps the old style ‘Age Allowance’, a higher personal allowance for the elderly, should be reintroduced for all pensioners.  If an Age Allowance of say £3,000 pa was reintroduced, this would mean many pensioners having total personal allowances of £12,570 + £3,000 = £15,570 pa, meaning millions of pensioners would remain below allowances and not have to wrestle with unexpected tax bills at the end of the tax year as well as temporarily removing the potential administrative ‘disaster’ for HMRC whilst a State Pension PAYE system is being built.