The PAYE System
The vast majority of people in paid employment or in receipt of a pension receive their income after tax and National Insurance has been deducted. The process for doing this is known as PAYE (Pay As You Earn) and employers and pension providers are required to ensure that the right amount of tax is deducted from an individual’s pay packet and handed over to HMRC as and when they get paid.
For most people, this is a relatively straightforward affair – they are entitled to earn a certain amount each year free of income tax (known as the Personal Allowance) and then pay income tax on anything above that amount. For the tax year 2022/23, the personal allowance is £12,570, which means earnings up to this level are not taxed.
However for some, things are not always that straightforward. They may have paid too much or too little tax in a previous year, taken the option to share their personal allowance with a partner or may even have more than one job. Where someone’s tax situation deviates away from the average, HMRC may choose to collect or refund any changes to income tax due through the PAYE system by making adjustments to an individual’s tax free allowances.
What Is a Tax Code and What is it Used for ?
HMRC uses tax codes to tell payroll administrators how much tax should be deducted from someone’s pay. A tax code usually has two parts – a number and a letter, for example1257L
The number part of the tax code is an employee’s tax free allowance divided by 10 – so in the case of the tax code of 1257L, employers are being told that the employee is entitled to £12,570 of income before they get taxed. If their tax code was (say) 423T instead, it would mean that the employee was entitled to just £4,230 of tax free income (so a lot less than the full allowance).
Under the PAYE system, the personal allowance is allocated evenly across each pay period, thus ensuring an employees tax bill is spread over the year. What this means in practical terms is that an individual on a tax code of (say) 1257L will be able to earn £1,048 each month or £242 per week before they pay any tax. The cumulative application of tax allowances across the year also means that if someone has not worked in the year but then starts work (say) four months into the year, they will be allowed to earn 4 x £1,048 = £4,192 before they pay any tax – this amount then increases by £1,048 per month or £252 per week thereafter.
The basic tax code can be changed up and down during the year. There may be other amounts to add to the basic personal allowance which will increase the amount someone can earn before paying any tax – and therefore reduce the amount of tax they have to pay on their wages. Likewise, there can also be deductions, such as tax underpayments, that reduce the amount a person can earn before paying any tax and therefore increase the amount of tax they have to pay on their wages.
The Letters that follow the number in a tax code are used to convey information about an individual’s tax status to employers. The main ones are as follows :-
Emergency Tax Codes
From time to time and to deal with specific situations, HMRC may issue special Emergency Tax Codes where instead of applying allowances cumulatively (as discussed above), allowances are applied on a week’s or month’s pay in isolation. An example of such a code might be 1257 W1/M1 (which stands for Week1 Month 1). The best way to understand how an emergency code operates differently to a normal one is through an example.
Going back to the earlier situation of someone starting a job four months into the year having not worked previously, the (normal) cumulative method of applying allowances would see the first £4,192 of their pay in that month not being taxed and increasing by £1,048 per month thereafter. However, if they were on an emergency tax code of (say) 1257 W1M1, they would only receive one month’s worth – £1,048 – of pay free of tax to use against that month’s wages and £1,048 in each subsequent month. In these situations, PAYE is operated non-cumulatively, which means they do not get the benefit of their unused allowance since the start of the year. This will generally happen until a proper code is received from HMRC. Then the cumulative basis may come in to play.
HMRC will generally issue emergency tax codes where an employee’s pay and tax details for an earlier part of the tax year are not known. Using an emergency code means they will be getting some benefit of the personal allowance each pay period, but the likelihood of there being a significant over or underpayment of tax at the end of the tax year is reduced.
Sometimes, HMRC may issue an employee with a negative tax code – this will usually see the number prefixed by a “K”, for example K350. Where such a code has been issued, the tax payable by an employee is worked out by adding the amount advised by the code onto an employees pay and calculating tax on the higher number (in other words, the employee is paying tax on more than their usual taxable pay). A typical example of where such a situation may arise is for employees who receive benefits in kind from their employers. Consider the case of an employee who has a company car on which the benefit in kind has been assessed at £13,000 per annum and who also receives private healthcare valued at £1,500 per annum. HMRC will calculate their tax code by deducting £14,500 from their personal allowance of £12,570, resulting in tax payable on an additional £1,930 of income per annum that isn’t in their pay packet. Their taxcode would therefore be K193.
Employees With Another Job
People who work part time may have more than one job. Where that is the case, the employee will often be issued with a BR tax code because HMRC assume all of their tax-free amount will be used against the first job and that therefore any wages from the second job need to be taxed at 20% (BR) to ensure there is no underpayment at the end of the year.
If someone is earning only a small amount in their second job, which when added together with the earnings from the first job doesn’t exceed the personal allowance, the employee can contact HMRC and ask them to split the allowances so that they do not have tax deducted by either employer.
How DoesSomeone Know What Their Tax Code is ?
Tax codes are usually found on payslips or documents such as P60’s and P45’s
Many people will also receive a form P2 Notice of Coding from HMRC in the post just before the start of the tax year telling them what their tax code for the year ahead will be.
Likewise,employers are also told what tax codes to apply to their employees pay for the pay period in question and where circumstances change throughout the year, HMRC will issue updated notices to both employers and employees.
What do you do if You Think Your Tax Code is Wrong ?
PAYE usually works best when an employee has a single, stable job that lasts a complete tax year. In any other situation, an employee could end up paying too much or too little tax by the end of the year. In these circumstances, HMRC will normally send out a tax calculation – form P800 – at some time after the end of the tax year when they put all the employee’s records together. The P800 will tell the person that there is either an underpayment of tax (which will probably be ‘coded in’ and collected later on down the line via PAYE) or an overpayment of tax (in which case a refund cheque should follow shortly
However, if at any point in the year someone believes that their tax code is wrong, they will need to contact HMRC directly themselves (HMRC won’t speak to an employer about an employee’s personal tax affairs) and discuss any changes needed. Contact details can be found here