What does my tax code mean?
The employee’s tax code is used by employers to calculate the amount of income tax that must be withheld, or deducted, from the employee’s wage or salary. The tax code is the mechanism by which ‘Pay As You Earn’ (PAYE) is operated in the UK by Government via HM Revenue and Customs (HMRC). The PAYE system is designed to make it possible for most employees to pay the right amount of income tax by the end of each tax year. As a result, most employees in the UK do not have to complete an income tax return.
Tax Codes that End with a Letter
These are referred to as ‘suffix’ codes – for example, codes 747L, 788P, 1005V 0T are all suffix codes. For the purpose of calculating the tax due through the payroll, the actual suffix letter is irrelevant; it is only the number that is significant. (See ‘What does the letter at the end of my tax code mean?’)
The number part of the tax code acts as an instruction to the employer of how much is allowed against your earnings before income tax is calculated. In all cases, the letter should be removed and a 9 added to the end of the numbers. This is then converted to a monetary value, i.e. £7,449.00. This monetary value represents the annual amount that can be earned free of tax. For example:
An employee has a tax code 744L. To calculate what this means in terms of the amount that can be earned free of tax:
- Remove the suffix letter – i.e. 744L tax code becomes 744
- Add a 9 to the end – i.e. 744 becomes 7449
- Convert to a cash value – i.e. 7449 becomes £7,449.00
£7,449.00 represents the amount of pay which can be earned free of tax over the tax year. This is called ‘free pay’.
However, the employee is not given the whole tax year’s tax free allowance in one go. Rather, it is allowed against the wage or salary in equal instalments throughout the tax year. For example, using the above tax code and assuming that the employee is monthly paid, the employee will be allowed to earn £620.75 per month free of tax (£7,449.00 / 12). Any earnings above £620.75 will be subject to tax via the PAYE system.
Note that if the employee is weekly paid, the annual allowance is divided by 52 weeks, if fortnightly paid by 26 weeks etc.
The next question follows, then, that how do HMRC know what tax code to allocate (i.e. how so they know how much money the employee should earn free of tax each tax year?). Annually, the Government sets the personal allowance that is applicable to each taxpayer. For example, the personal allowance for the 2011/12 tax year is £7,475.00, which is expressed as tax code 747L. This is the starting point for HMRC in allocating a tax code. Many people will be entitled to the personal allowance and nothing more, however, others will have factors which may increase of decrease this amount. For example:
If the number part of a suffix code is lower than 747L, this could mean:
- There is tax owed from a previous tax year which HMRC are recovering each pay period by reducing the tax code
- There could be taxable benefits included in your tax code which your employer has provided but on which tax has not yet been paid – i.e. medical insurance, company car
If the number part of a suffix code is higher than 747L, this could mean:
- There is an entitlement to another tax allowance which has increased the basic personal allowance
- There may be some tax adjustment due to be repaid, and HMRC are repaying this by increasing the tax code and repaying it over the course of the year rather than in a lump sum
However, the above information is only provided as a guide. The tax code is unique and personal to each individual. Two people with, seemingly, the same circumstances, could be on totally different tax codes because of their personal circumstances. This is why HMRC sends the P2 Coding Notices out to taxpayers at the time the tax code changes. This form explains in details how the tax code is made up.
Tax Code 0T
Special reference is made to this suffix code, as there are a number of reasons that an employee may be on this code. Simply, it means that the employee is entitled to 0 (zero) personal allowances. This means that they will pay tax on all of their earnings. The code could be used in one of a number of circumstances, for example:
- Most simply, the value of the personal allowances and the value of the deductions to be made from the allowances are exactly the same – i.e. the person is entitled to zero personal allowance
- The person may be a student who has exceeded all personal allowances whilst working during vacation periods
- At the time of starting employment, the new employee did not present a P45 nor did they tick one of the earnings statements on the form P46. In this circumstance, HMRC guidance is that tax code 0T is used
- The person is a pensioner, receiving a pension but working for the same employer, or
- The tax code has been used to make a payment to an employee that has already had tax form P45 issued (a payment to a leaver). In these instances, regardless of the tax code that may have been used, HMRC guidance is to use 0T
Tax Codes that Start with a Letter
These codes are referred to as ‘prefix’ codes – simply, the letter is at the start of the number rather than at the end of it. There are a number of prefix codes, all deserving a separate section:
Normally, the employee will be allocated their personal allowances by HMRC, and this will result in the issue of a suffix tax code, described above. This will allow the employee to enjoy a free pay amount every time they are paid, therefore, they pay tax on less money than they actually earn.
The simple explanation of a K code is that HMRC have allocated personal allowances to the employee, however, the adjustments they have made have resulted in negative allowances. For example, an employee is entitled to the standard personal allowance but had a company car in the previous tax year with a taxable benefit in the sum of £8,000. The tax code is calculated by HMRC as follows:
- Add Personal Allowances £7,475.00
- Less taxable benefits £8,000.00 equals
- Resultant allowances -£525.00
The effect of this calculation is that the person is due to pay tax on more money than their personal allowances. The -£525.00 will be rounded down to a tax number of 51 and a prefix K placed in front, giving tax code K51. This is then converted to a monetary value in the same way as above, i.e. K51 becomes £519. This monetary value represents the annual amount that must be added to taxable pay. For example
An employee has a tax code K51. To calculate what this means in terms of the amount that has to be added to taxable pay:
- Remove the suffix letter – i.e. K51 tax code becomes 51
- Add a 9 to the end – i.e. 51 becomes 519
- Convert to a cash value – i.e. 519 becomes £519.00
£519 represents the amount of pay is added to taxable pay over the course of the tax year. This is called ‘additional pay.
As with a suffix code, the employee is not taxed on the whole of the additional pay one go. It is allowed against the wage or salary in equal instalments throughout the tax year. For example, using the above tax code and assuming that the employee is monthly paid, the employee will be taxed on an additional £43.25 per month (£519.00 / 12). So, if earnings in the month were £1,000.00, the employee would pay tax on £1,043.25.
D Codes apply where HMRC calculate that the employee is liable for tax at either the Higher (40%) or the Additional (50%) rate of tax. The employee may get this, most commonly, in the circumstances that he or she has more than one job. As the employee is only entitled to one set of personal allowances, this will be applied to job one through a tax code, and any second (or third) jobs will be taxed using the D Codes. However, these codes will only apply when HMRC realise that a subsequent employment will take the employee into one of the higher tax brackets. They do not allow the employee any ‘free pay’ and:
- Code D0 will tax the employee at 40% on all earnings
- Code D1 will tax the employee at 50% on all earnings
This code is an abbreviation of ‘Basic Rate’. It is applied by HMRC to employees who are liable to pay income tax on all earnings at the Basic Rate of tax, currently 20%. There is no ‘free pay’ or ‘pay adjustment’. An employee may be given this code, generally where there is a second employment, possibly:
- The employee has two or more jobs, or a pension, and a tax code is allocated against the first income. HMRC calculate that all tax payable in subsequent employments is due at the Basic Rate
- A new starter ticks box C on the P46 which allows the employer to use code BR
This code is an abbreviation of ‘No Tax’ or ‘Nil Tax’. Only HMRC are permitted to issue this code and it is applied exceptional circumstances to employees who are not required to pay tax on their earnings. The most common example would be for international (expatriate) employees where HMRC decide that noUKtax is payable earnings paid in theUK. Another common use, though strictly incorrect, is for students who are working in their vacation periods. Students who sign the P38(S) should, in fact, be placed on tax indicator NI by the employer, rather than tax code NT, which should only be issued by HMRC.