How to break your tax code

The Inland Revenue data is often out of date Anthony Bailey explains how to ensure you do not end up paying over the odds

MILLIONS of tax codes due to take effect next week could be wrong - because they are based on out-of-date information.

The codes recently sent out are for the coming tax year, beginning on 6 April. But anyone who has received a notice of income tax coding should check it carefully and contact the tax office if the code is wrong.

Decoding the code is not easy. A coding notice has two columns. In the left-hand column are tax-free allowances and items for which tax relief is given. This might include higher-rate tax relief for personal pension payments and relief for mortgages which fall outside the Miras system. In the right-hand column are things that need to be taxed, in addition to pay. There may be taxable benefits - for example, company cars and luncheon vouchers are common benefits in kind.

Other items might include outstanding tax from an earlier tax year and taxable state benefits, including the state pension, which is taxable, though not taxed at source.

But the value of these items may change in the coming tax year. For example, people who no longer have company cars or luncheon vouchers will end up paying too much tax.

To get the actual code, the figures in each column are added up. The total for the left-hand column is deducted from the total for the right- hand column. The last digit is then knocked off to get the code.

One of the newer mysteries of the tax-code form is an allowance restriction that appears in the right-hand column. It is given to people who receive fixed-rate allowances, such as the married couple's allowance and the additional personal allowance - both £1,720.

Until the current tax year, these allowances were simply set against income and in effect gave tax relief at an individual's highest rate of tax. But last April the tax saving was fixed at 20 per cent for all taxpayers. This goes down again to 15 per cent on 6 April - and will be worth just £258 in the hand.

In order to keep the tax saving to 15p in the pound, a restriction is imposed, its size depending on an individual's expected top rate of tax for the coming tax year. If someone's top rate of tax is 20 per cent, the restriction will be £430. Here's how the sum works. Without the restriction, a 20 per cent taxpayer would save £344 in tax: that is, £1,720 multiplied by 20p. Bringing £430 back into tax collects another £86 (£430 multiplied by 20p). Deduct the £86 from £344 to get £258, the correct tax saving. The restriction for 25 per cent taxpayers is £680 - a rounding down in the taxpayer's favour from the correct figure of £688. For higher-rate taxpayers the restriction is £1,075. There will be different restrictions for people who receive the higher age-related married couple's allowance. Higher age-related allowances will be reduced once total income exceeds £14,600. Again, the tax office has to estimate the likely level of income, and the estimate could be wrong.

For anyone else whose income and top rate of tax is likely to change from April, the restriction could be wrong. And there is a further problem if income takes someone only a short way into a higher tax band.

"For certain income brackets the Pay As You Earn coding system cannot cope with the reduced value of the married couple's or additional personal allowances," says Richard Bosley, an accountant.

"There are probably thousands of people who will be paying too much tax - with little or no chance of the overpayment ever being discovered."

But mistakes can be put right retrospectively. When people have received the final pay cheques for the current tax year by the end of this month, they should make sure they have not paid the wrong amount of tax over the preceding 12 months.

The letters in a tax code give some insight into the assumptions made by the tax office.

People who get the basic personal allowance (£3,525 from 6 April) are classed by the letter L. Taxpayers who receive only this allowance and have straightforward tax affairs are not sent a customised coding notice - though their employers will be told what code to use (352L).

Taxpayers who receive the basic allowance and the married couple's allowance receive the letter H. P is for people aged 65 to 74 who get the higher age-related allowance, while V is for those who get the higher married couple's allowance as well.

BR means all pay is taxed at 25 per cent; DO that it is all taxed at 40 per cent; and OT that it is taxed at 20, 25 and 40 per cent, as appropriate. K means that items to be taxed, such as company cars, exceed allowances. NT means no tax will be deducted.

Finally, a T code is used for a variety of circumstances: for example, if a wife receive some or all of the married couple's allowance, or when people over 75 receive the highest age-related allowances. There is no time limit on correcting a coding, but it makes sense to do it right away.