It can be a challenge to decipher the meaning behind a new tax code. Here is our guide to understanding the letters and numbers, and why adjustments are made.
PAYE codes, or tax codes, can be a confusing matter for employees and employers alike.
HMRC calculates an individual’s PAYE code based on the income information it has on record. It issues a PAYE coding notice (referred to as form P2) to the employee to tell them their tax code at the beginning of each tax year and explain how it has been worked out.
Around the same time, a form P6 is issued to the employer so that the tax code can be included in the employee’s payroll record. This is used to determine the amount of tax that is withheld each month. The tax code can be found on the payslip.
A PAYE code is made up of a combination of numbers and letters:
- The numbers represent how much tax-free income the individual is entitled to receive each year. A new code is issued annually to update for any changes in their personal allowance/circumstances for that tax year. PAYE codes are usually no more than four numbers plus one letter, but the personal allowance on which the code is based is £12,570 (five digits). To make up the code, the last digit of the allowance is always dropped and replaced with a letter. So, for someone entitled to a full personal allowance, their tax code would start 1257.
- The letter relates to an individual’s personal tax situation and how it affects the amount that can be earned tax free. Someone entitled to the full tax-free personal allowance will have an L following the sequence of numbers, so it will be 1257L.
HMRC also uses other single letters and combinations of letters for people who are not entitled to the full tax free personal allowance for a variety of reasons.
- Scottish or Welsh taxpayers also have a letter at the beginning of their tax code: S if they live in Scotland, or C if they live in Wales. This is because the personal allowance and tax bands are different from those in England and Northern Ireland.
- The standard position is that PAYE is calculated on a cumulative basis, so each month takes into account what has gone before. However HMRC also uses what are known as ‘emergency tax codes’ when it doesn’t have accurate details about how much tax should be paid. This can affect the basis for the tax calculation. It may mean each month is considered in isolation, with 1/12 of the personal allowance (if due) and 1/12 of the rate bands allocated regardless of what has gone before.
So far so good, and if we stopped at this point PAYE codes would not be the source of frustration that they are for so many.
Confusion can creep in because the adjustments are not easy to follow and often leave employees and employers scratching their heads about what is happening – let alone whether it is right or not.
HMRC makes adjustments to the basic PAYE code for many reasons. We look at the most common below.
Employer provided benefits
If an employer does not payroll its benefits, instead reporting them on form P11D at the end of each tax year, the benefit is not taxed via PAYE withholding like a cash payment but through an adjustment to an individual’s tax code. This ensures that tax due on the benefits is collected evenly throughout the year.
This type of adjustment lowers the number in the PAYE code, thereby reducing the amount of the personal allowance. So if a person receives £4,000 worth of benefits, the PAYE code would reflect this, being 400 lower than the standard PA code, i.e. 857 instead of 1257 (remembering the last digit is dropped).
The adjustment for employer benefits often occurs in-year, when HMRC receives new information about the benefits. This particular adjustment only happens once per year, unless the employee has a company car, and then an adjustment may follow the filing of form P11D in July. So adjustments to codes are usually made between August and October.
If an employee has submitted a claim to HMRC for job-related expenses, which were not reimbursed by their employer and are likely to be claimed each year (rather than being a one-off expense)), the employee’s PAYE code is adjusted upwards so that they receive the tax benefit throughout the year.
Reduction in personal allowance
People who have taxable income of between £100,000 and £125,140 in a tax year have their personal allowance restricted by £1 for every £2 earned over £100,000. It is eventually phased out completely for income of £125,140 or above. This would result in produce the tax code 0T, rather than the traditional number-letter format.
Tax owed from an earlier tax year
This is the one that causes most confusion. Despite HMRC’s best efforts to try to ensure employees pay the right amount of tax each year via withholding, it is rarely 100% correct. What causes these inaccuracies? Differences in the value of the benefits received during the year, a change in income meaning more or less of a restriction to a personal allowance and employee expenses being more or less than the previous year, are some examples that result in amounts of tax payable or refundable each tax year.
Adjusting the PAYE code in this way helps the taxpayer with cash flow by ensuring they do not need to fund a one-off payment to HMRC, which many would struggle to do. Instead, they pay the amount owed throughout the year through an increase in the monthly figure withheld from their pay and paid over to HMRC.
What is confusing is when the adjustment to the PAYE code is made because of tax owed in an earlier year. In this case, it isn’t a direct transposition of numbers as it is for employee benefits or expenses.
The adjustment is always a larger amount because PAYE codes are applied to the amount of earnings needed to generate the income tax, rather than the tax itself. So the adjustment is calculated by working backwards from the tax owed to how much actual income has to be surrendered to generate that amount of tax.
For example, if a taxpayer owed £700 for a tax year and they were in the 40% tax bracket, an adjustment of £1,750 would be made to the code (as a reduction in the number) (£1,750 x 40% = £700).
Refunds are always repaid directly to the taxpayer as a lump sum, but millions of employees owe tax at the end of a tax year. Where the amount of tax owed is less than £3,000, HMRC collects it by making an adjustment to the taxpayer’s PAYE in a future year. Where it is more than £3,000 a direct payment must be made by the individual to HMRC
PAYE codes can be adjusted for more than one reason. If there is a K at the beginning it means there is income not being taxed in another way and it is more than the tax-free allowance. This kind of adjustment can mean a significant loss of net income.
When adjustments occur, many employees turn to their employer for an explanation. However in reality employers are not responsible for ensuring the PAYE code for each of their employees is correct. Employers are only responsible for using the PAYE code received from HMRC (usually via a monthly feed) when the next payroll is run.
Employees are responsible for ensuring their own PAYE code is correct and notifying HMRC of any changes (for example, a benefit no longer provided). An employer will not have oversight of how the code was calculated or be able to do anything about it, except in very specific circumstances usually involving internationally mobile employees.
An employee can manage their tax code online once they have set up a personal tax account via HMRC online services. Alternatively, the employee can call the self-assessment helpline on 0300 200 3310.
Although employees are responsible for their own PAYE code, it helps if their employer has an understanding of the common reasons why PAYE codes are adjusted. That should mean an employee’s query is quickly dealt with when they knock on payroll or HR’s door, and avoids the need to wait for answers on the helpline.
For convenience, we include HMRC’s explanation of what the PAYE code letters mean:
You’re entitled to the standard tax-free Personal Allowance
Marriage Allowance: you’ve received a transfer of 10% of your partner’s Personal Allowance
Marriage Allowance: you’ve transferred 10% of your Personal Allowance to your partner
Your tax code includes other calculations to work out your Personal Allowance
Your Personal Allowance has been used up, or you’ve started a new job and your employer does not have the details they need to give you a tax code
All your income from this job or pension is taxed at the basic rate (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the higher rate (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the additional rate (usually used if you’ve got more than one job or pension)
You’re not paying any tax on this income
Your income or pension is taxed using the rates in Scotland
Your Personal Allowance (Scotland) has been used up, or you’ve started a new job and your employer does not have the details they need to give you a tax code
All your income from this job or pension is taxed at the basic rate in Scotland (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the intermediate rate in Scotland (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the higher rate in Scotland (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the top rate in Scotland (usually used if you’ve got more than one job or pension)
Your income or pension is taxed using the rates in Wales
Your Personal Allowance (Wales) has been used up, or you’ve started a new job and your employer does not have the details they need to give you a tax code
All your income from this job or pension is taxed at the basic rate in Wales (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the higher rate in Wales (usually used if you’ve got more than one job or pension)
All your income from this job or pension is taxed at the additional rate in Wales (usually used if you’ve got more than one job or pension)
If you have any further queries about PAYE codes, please contact Aisling McCartan, Manager in our Employment Tax team.
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