Analytical Superpower vs Tax Relief: How Numerical Skills Came to Rescue in a Major Payroll Error

Analytics
Written By Bingqian Gao

I always had this idea that being able to work with data is like having a super power. I recently had just the case to prove this point. 

Actually this is not even so much about big data analytics, but more numerical skills (such as maths, basic calculations, and working with Excel), consulting skills (collecting data, inputs and evidence, performing analysis and documenting everything in a report), and independent thinking (not blindly trusting or undermined by the so called professionals).

The intention of this article is to share the important knowledge about UK pension tax in one place, and explain the calculations with clear and easy to understand mathematical reasoning and examples. It’s also to share a little bit about the experience of this intriguing battle against a well established and resourceful but somewhat ineffective and unaccountable corporate, which was an enriching life experience that will be one to remember for a while.

What happened?

So, I had been puzzled by my income tax since I started this job 3 years ago. 


I was convinced that I was not paying the right tax. Each year when I worked on the tax self assessment, I got more confused by the numbers on the payslips and P60. I raised the issue with my employer, with the third party company that processes our payroll, and hired an accountant. We didn’t manage to get to the bottom of it. As a statistician by training and a data analytics professional with a decade of experience but had never ventured into tax, I decided to take on this challenge myself. 

So I spent several weekends and evenings, reading up everything there is to read about the UK income tax, learning about the various sorts of tax reliefs, and turned myself into an income tax expert. 


Loooooooooong story short, the payroll company made a mistake in processing our payroll and coded taxable income wrongly, which meant we overpaid taxes. Our pension scheme is processed with the “Net Pay” method (which I talk about more below), but the contribution was taken from our after tax pay instead of before tax pay. Two things that made the situation worse: 1. The customer service from the payroll company was not great, to say the least, and communication with them was difficult and I either got vague, dismissive, or no response at all when I tried to discuss issues I found with them. 2. There was a period of 8 months when they actually accidentally corrected this, but later on they called a meeting with all of our UK employees telling us they “made a mistake” and we had to pay “back” the tax that we “underpaid” during those 8 months. 

I raised concerns on the pension amount, tax code and taxable pay amount numerous times. Each time the concerns were either dismissed or ignored by the payroll company. There were even several times that the representative of the company came back to me 100% convinced that he was right and I was wrong, even after I compiled all the evidence in a detailed documentation, and had validated my findings with several organisations including HMRC, the UK Pension Ombudsman, Money Helper, and my accountant. 

It took hundreds of hours of work and almost three years of fighting to finally get Vistra, this payroll company, to acknowledge their mistake, and we are now in the process of figuring out how to rectify it. We are talking about tens of thousands of £££ (and who knows how many other UK businesses and employees are affected)!!!



Why 40% tax band doesn’t mean 40% tax relief?

This is very important, not very intuitive, and not very well documented or explained on government or pension/tax educational sites. But if you understand the basic maths, and spell out the formula of how tax is calculated, you’ll quickly understand this. 

Say you are a higher band taxpayer, which is 40%. If you pay £100 into your self-invested personal pensions (SIPP), this money comes out from your AFTER-TAX income. (And in our case the payroll company wrongly processed the payroll and also took the pension contribution from the AFTER-tax pay incorrectly, making the situation somewhat similar.) In such a situation, you want to calculate what tax relief you can get. 


Now because the £100 you contributed had already been taxed, to calculate the before tax amount, you need to solve the below equation (Before Tax Pay -> BTP): 

BTP*(1-40%) = £100

So this means BTP= £100/(1-40%)=£166.67

This means the Before Tax Pay was £166.67, which should have all gone into the pension pot since you don’t pay tax on the amount that you put in your pension, so you should get a “free cashback” into your pension that is 166.67-100 = £66.67.

This is a 66.67% “cashback”, not 40%. 


Say if you’re an additional band taxpayer, the £100 you contributed had already been taxed at 45%, to calculate the before tax amount, you solve the same equation with 45% tax rate: 

BTP*(1-45%) = £100

So this means BTP= £100/(1-45%)=£181.82

This means the “free cashback” amount that should be paid into your pension pot is 181.82-100 = £81.82.

So that’s a cashback factor of 81.82%, not 45%!

So, to give you specific numbers as an example, in order to have £1000 in your pension:

  • If you are a 40% taxpayer, it’ll effectively cost you £600 (£200 from basic tax relief, a further £200 from higher tax relief)

  • If you are a 45% taxpayer, it’ll effectively cost you £550 (£200 from basic tax relief, a further £250 from higher tax relief)

So again, if you look at the instant “ROI” (return on investment), 1000/600-1=66.67%, 1000/550-1=81.82%.

So keep those % (e.g. 66.67% and 81.82%) in mind when you are considering your pension contributions, especially when you are paying more than the basic tax rate. 

One more thing to know about pension tax relief, just to make it even more complicated, is that there is something called Personal Allowance( which is £12,570 for the current tax year). Now the complicated bit is, if you make more than £100k, your Personal Allowance goes down by £1 for every £2 that your adjusted net income is above £100,000. This is also known as the 60% tax trap (someone earning between £100,000 and £125,140 faces an effective 60% tax rate on that portion of their income.) This means your allowance is zero if your income is £125,140 or above. And now, if your income is somewhere near £125k (say between £100k to £180k), by contributing to pension, it lowers your taxable income, which means it might increase your personal allowance which lowers taxes even more than the previously calculated %s. This is the largest % tax relief you’d get, and the most complicated to calculate, but your accountant should be able to help you with that. This will not affect you if your income is lower than £100k (since you will get the normal personal allowance) or WAY higher than £125k (like, if your annual income is £200k then no matter how much you pay into pension you will probably not get personal allowance anyway). Note that there are also limits of how much you can pay into your pension, called pension annual allowances, and it’s £60k for 23/24, which is reduced if your income is above certain threshold.




In UK, pension tax relief is realised in different ways

And so you don’t simply get the % calculated as the above section illustrated in one lump sum. That’s what makes it confusing. 


There are three ways (workplace) pension contribution are processed in the UK, and to make it worse they have somewhat misleading names. And perhaps this is why the Payroll company was confused and made such a big mistake (and insisted on being confused) which took me almost three years fighting with them to get it corrected! It was incredibly confusing for me at first, but after spending some time on understanding the mechanism, it started to become clear. So there is hope for all of us!  


In simple terms, there are 3 ways that a pension contribution can be set up: 

1. Net Pay:

You contribute X from BEFORE TAX income (note that the official name for the method is a bit misleading here), then that amount is deducted from the total taxable amount, meaning that you are not taxed in your PAYE for that amount. So there is also no need to claim back any further relief with self assessment no matter which band of taxpayer you are. There will be £X in your pension pot.

2. Relief at source:

You contribute Y from your AFTER TAX income (this amount had already been taxed), then your pension provider will automatically claim 25% cashback on your behalf from HMRC which goes straight into your pension pot - this is the tax relief on the basic 20% rate. Why 25% cashback instead of 20%? Same reason as the above. As a basic tax rate payer, if the after tax amount is Y, you can calculate the Before Tax Pay by solving: 

BTP*(1-20%) = £Y

So this means BTP= £Y/(1-20%)=£1.25Y

Which means the cashback is 1.25Y-Y=0.25Y, hence the 25% cashback as the basic relief.

Then, if you are higher (40%) or additional (45%) band taxpayer, you have to claim back the further tax relief with the self assessment. 

So there will be 1.25Y in your pension pot, and with the self assessment you will get a further Z amount back in cash (not in your pension pot). To know the amount of Z, I’ll spare you the headache of maths here as it’s easiest to check with online calculators (for instance https://www.pensionbee.com/pension-tax-relief-calculator). Check the reference section for instructions as some of them work differently from others.

For instance, example below:

if you enter your annual income of 100k (40% tax rate), and you want your pension pot to have £2000 in it, with a relief at source method, you take £1600 from your after tax net income, then the pension provider will automatically claim the 25% which is £400 and add it to the pension pot, then with the self assessment you claim back a further £400 in cash. This practically means you “paid” £1200 from your pocket, to have £2000 in the pension pot (this is consistent with the 66.67% cashback illustrated in the first section). Great deal! And sometimes employers match your contribution too, making it an even better deal.

 
UK Pension Tax Relief Calculator
 
 
UK Pension Tax Relief Calculator result
 


3. Salary sacrifice:

This is the best way for employees, but needs your employer to sign up for this.

You can still choose your contribution % the same way, but in your pension pot it’ll show as if the whole contribution is coming from your employer. 

You pay less Income Tax and National Insurance, and don’t need to worry about claiming further tax relief. 


You can read more about all three methods here. 


The Process to Resolution

I thought I’d share the process that I went through in this challenging battle, for a good story but also in case someone else find it useful if they encounter something similar in fighting a battle against incompetent or ineffective professional organisations (not just in tax). Unfortunately such systematic negligence and subsequent dismissive and irresponsible corporate behaviour happen, and normal people suffer.

After trying and failing for two years trying to get Vistra to investigate this payroll error, I took the below process which eventually led to the resolution:

  1. Researching, reading, and learning about UK tax. This includes but is not limited to: reading content on various governmental websites and non-governmental pension/tax educational pages, watching videos where tax experts talk about how pension tax and relief works, reading term sheets from pension providers, etc.

  2. Collecting data and evidence, perform calculations and form an opinion of what happened. I pulled all the payslips and P60 data into Excel (Google sheet), and did the calculations. I called up our pension provider (Smart Pension) to request written documentation of how our pension scheme should work. I watched the recording of the meeting Vistra had with our UK employees, and noted down what the representative said that did not match the UK tax laws. I also collated all the back and forth in email communication I had with Vistra, which also evidently showed how dismissive and careless they were this whole 2.5 years.

  3. Validating the findings with professionals. I checked and rechecked the calculations, and re-validated these against the laws / rules many times, because I want to be absolutely sure, and also because I had been told I was wrong so many times by (Vistra) people that were supposed to be professionals in this field. I called up HMRC, MoneyHelper, UK Pensions Ombudsman, and my accountant, and validated my understanding and findings.

  4. Documenting and filing a formal complaint. I documented everything into a report, and submitted a formal complaint, looping in my company’s HR department, and also notified and opened a case with UK Pensions Ombudsman (they can step in if there is no satisfactory response after 8 weeks of raising the complaint).

Going through this process (which amounted to hundreds of hours) finally kicked off a formal investigation (after yet some more dismissive pushbacks and delays from Vistra, I regret to say). And now two months later after weekly chasing and check-ins and pressing them to provide updates and timelines, we have finally got Vistra to acknowledge the mistake. They have allegedly fixed things for the future, and we are trying to work out how to amend the past wrongly filed details with HMRC as well as helping affected employees reclaim overpaid taxes in the last several years.

Pension should be the top of your no-brainer investments

Given the instant return rates of 25%, 67% and 82% or even more described above, pension should be one of the top investment options, especially if you pay higher taxes. 

Of course, knowing how to invest your pension money well is another good skill to have. There are many options ranging from more control on exactly what assets you want to invest in, to less control and just indicate your risk preference and let someone else (or a robot) choose the underlying investment. This is another topic that I won’t elaborate here but there are a lot of resources you can read and learn from online, perhaps starting with your existing pension providers.

Other ways to achieve tax efficiency

In investigating and studying this tax issue, I also learned about all those tax reliefs you can have. I will probably write another article about the various ways you can optimise your tax, legally. 





Main references and organisations that can help if you face pension or tax issues:


Disclaimer: All opinions are my own and are for reference only. You should do your own research and consult a qualified financial advisor (which is NOT me but you are more than welcome to chat with me on these topics) for your investment options.

If you find this helpful in any way please leave a comment to let me know, and share with others that can benefit from it!


Bingqian Gao
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