If you are an employee, your employer will deduct tax from your wages or salary under the Pay As You Earn (PAYE) system. This takes the hassle out of filing your own tax records and paying your own tax and National Insurance contributions.
But what exactly is PAYE and how does it affect employers and employees in small and medium sized businesses? In this article we will look to answer these questions and more. Let’s begin.
What is a PAYE tax code?
PAYE is a method of paying income tax on an employee’s income. HM Revenue & Customs (HMRC) issue a PAYE code to an employer, telling them what tax-free earnings their employees are entitled to in a particular pay period. This will allow an employer to tax the employee at the appropriate rates.
An employee may also receive a copy of this PAYE code in the form of a PAYE coding notice (form P2). Their payslips should also show the PAYE code the employer is using. Even if an employee does not get a P2 they should be able to view their PAYE tax code in their Personal Tax Account.
What does a PAYE tax code look like?
A tax code takes the form of several numbers and a letter. The most recent standard tax code is 1257L and is used for most people who have one job or pension.
What do the numbers in a tax code mean?
The numbers in a tax code tell an employer or pension provider how much tax-free income an employee can get in a specific tax year.
HMRC works out the number based on an individual’s tax-free Personal Allowance and the income they have not paid tax on as well as the value of any benefits they might receive from their job, such as a company car.
What does the letters in a tax code mean?
Letters in a tax code refer to the individual’s situation and how this affects their Personal Allowance.
Here is a brief guide to a few of the more common codes:
- L – An employee is entitled to the standard tax-free Personal Allowance.
- M – an employee has received a transfer of 10% of their partner’s Personal Allowance. This is called Marriage Allowance.
- N – This also stands for Marriage Allowance but means that an employee has transferred 10% of their Personal Allowance to their partner.
- T – The tax code includes other calculations to work out an employee’s Personal Allowance.
- BR – This means that an all an employee’s income from their job or pension is taxed at the basic rate. This usually means they have more than one job or pension.
- NT – This means an employee is not paying any tax on their income.
- K – Tax codes with ‘K’ at the beginning mean that an employee has income that is not being taxed another way and it’s worth more than their tax-free allowance.
What if my tax code includes ‘W1’ or ‘M1’ or ‘X’ at the end?
Codes W1, M1 and X are emergency tax codes.
What is an emergency tax code?
An emergency tax code is used by an employer when they do not have sufficient information to put an employee on a standard tax code such as 1257.
HMRC may apply an emergency tax code to an employee’s salary if it doesn’t have enough details about how much tax they should pay. This means they may miss out on tax-free allowances and pay more tax than they should.
The most common time where an employee will be put on an emergency tax code is when they’ve just started working for a new company.
Other reasons why an employee might pay emergency tax include:
- They’ve started a new job for an employer after being self-employed.
- They’ve started or stopped getting benefits from a job.
- They receive taxable state benefits.
- They claim marriage allowance or expenses that they get tax relief on.
Emergency tax codes are applied to your salary automatically by HMRC, but only as a temporary measure. Once HMRC has more information about how much you’re earning, your tax code will be adjusted, and any overpayment refunded.
How does PAYE work for employees and employers?
There are three parties involved in the PAYE process – HMRC, an employer (or pension provider) and an employee. Here is a brief description of how PAYE tax codes affect each.
HMRC calculate a tax code for an employee based on the information they have about them.
They will send a PAYE coding notice to the employee showing them how they have worked out the tax code. They will also notify the employer of the tax code so they can start deducting tax for the employee.
The employer (or pension provider) will use the tax code the HMRC have sent them to work out how much tax to take from an employee’s weekly or monthly pay. They will then, on a regular basis, pay this tax (as well as any National Insurance contributions) to the HMRC.
The employee’s role in the PAYE process is quite limited and passive. In general terms, the employee will pay the tax they owe above their personal allowance to the HMRC via their employer by having it deducted from their pay at source.
What does the law state about PAYE tax codes?
As with most things related to the government and its finances, PAYE tax codes are legally binding for all parties. Any employer or employee found to be (or attempting to) circumnavigate the tax code for their own gain is committing a criminal offence.
What if I have the wrong tax code?
If you think your tax code could be wrong, you should contact HMRC via telephone or email. The onus is on employees to make sure their tax code is correct.
What if I’ve underpaid or overpaid tax?
If the HMRC realise that you have overpaid tax they will inform you of a refund by post. The refund may be given as a cheque or as an adjustment to your tax code.
If the HMRC realise that you haven’t paid enough tax they will often recoup this through a tax code adjustment. This might mean you paying more tax until the end of the tax year. In some cases, for example – you are no longer in employment, they may issue a demand for payment.
What is a PAYE coding notice?
When your tax code is updated, you will sometimes receive a PAYE coding notice in the post from HMRC. This details the allowances and deductions you are entitled to and how they are used to work out your tax code.
PAYE tax codes can be confusing for employers and their employees. We hope that with a little hope from this guide you now find the topic a little easier to understand.