Why you need to keep an eye on your tax code

If you don't know what tax code you're on, you could be losing out; an incorrect tax code is the most common reason for paying too much income tax – especially if you are a higher-rate payer.

Taxpayers need to act now to claim back millions of pounds of overpaid tax, says John Greenwood in The Sunday Times. The time limit for backdating such claims is about to be cut from just under six years to four. The most likely cause of income tax overpayments is an incorrect Inland Revenue tax code, thought to affect one in five of us. You can find your tax code on your monthly payslip, or on the annual coding notification letter sent out by the Inland Revenue. Failing that, ring the self-assessment helpline on 0845 900 0444.

Each code comprises a number followed by a letter. If you ignore the letter and multiply by ten, you get an amount (543L becomes £5,430). With an "L" this represents the total income you can earn in the current fiscal year (6 April 2008 to 5 April 2009) before you pay income tax. For many, this is made up solely of the tax-free personal allowance set by the Government: currently £5,435 for under 65s. Employees receive the benefit in equal monthly sums as a reduction in the income tax collected from salaries.

The other common letter (there are several) is a "K", indicating that you are liable to pay additional tax this year £1,170 in the case of a K117 code, for example. This can arise when a higher-rate taxpayer receives lots of investment income. Although automatically taxed "at source" at 20%, it should all be taxed at 40%. Taxable non-cash employment benefits, such as a company car or medical insurance, also affect your tax code. If the shortfall in unpaid tax exceeds the personal allowance, the tax code turns negative, as indicated by the "K".

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Things get more complicated for higher-rate taxpayers with pension plans. Every time you and your employer pay into your retirement fund, the pension plan provider automatically claims 20% in tax back from HMCE, which boosts the amount invested. However, your tax code should also be adjusted in your favour so that you receive an extra 20% of tax relief so 40% in total on all contributions.

Trouble is, the extra relief will only be added to your personal allowance if you remember to tell HMCE about any pension contributions made by you, or on your behalf. Without this extra relief you join the many higher-rate taxpayers estimated to have paid too much income tax. If you believe your tax code is wrong, contact your local tax office.