Q - I've noticed that the software is giving my client 'tax credits'. Could you explain why and how the tax credits come about?
A - The general (and short) answer is that tax credits arise from the overpayment of taxes in the previous year. A more detailed answer is provided below:
In each year of the plan, the software carries-out 2 sets of tax calculations - firstly, at source and then, subsequently, at the end-of-year.
Taking the example of an individual who is a higher-rate taxpayer, the individual's full personal allowance is applied to employed earnings, in the first instance - tax & NI are calculated and deducted accordingly.
Let us assume that this individual is also making contributions, to a Self-Invested Personal Pension:
The contributions to the SIPP are made from post-tax earnings, and basic rate relief on the contributions is applied at source. Higher rate relief, on the other hand, is granted by the extension of the basic and higher-rate tax bands, at the end-of-year tax calculation (as shown below).
The extension of the basic rate tax band (illustrated above), of course, results in a reduction of tax to be paid at the individual's highest marginal rate. The result is that, when the software carries-out its end-of-year tax calculation, it recognises that the individual has overpaid tax in the current year and is entitled to a refund, as illustrated below.
Think of this as an adjustment to taxes that is made via the client's annual tax return. While it is possible that, in practice, some, or all, of this adjustment might be made via a change to an individual's tax code, the software doesn't model tax codes and all adjustments, therefore, are made annually-in-arrears, via the annual assessment.
Other possible reasons for tax credits are:
1. The inclusion of tax-deductible expenses.
2. Tax-deductible interest on mortgages.
3. Contributions to VCTs, or EISs, which qualify for a tax credit.
Each of the above is liable to result in a situation where the software carries-out the end-of-year calculation, and recognises that too much tax has been deducted at source. As such, the client will be entitled to a tax credit in the following year.
Further reading
Tax relief on contributions to Money Purchase Pensions