Do you understand your employees' tax code?

Tax codes can be confusing and employees will often ask their employers to explain them or explain why they are paying so much or so little tax.  They may ask why they have the tax code that they have.

PAYE tax codes are provided by HMRC

The tax code that an employee has on their payslip is provided to them and to you, their employer, or to your payroll provider by HMRC and is implemented on the next payroll processing after receipt.   You or your payroll provider do not decide what tax code they should be on except when they are a new starter without a P45.  Completion of the new starter declaration will tell you which tax code they should be started on depending on which of the three statements they choose.   HMRC will notify the employee and you or your payroll provider of any change in tax code after a new employee has started work with you and at any time during the year if there is a change to the employee's personal income.   

As a payroll provider we would not question a change in tax code because this relates to an employee's personal circumstances.  However if we think it is a significant or strange change we would inform the employer so they can alert the employee.  The employee should have received notification of the change from HMRC by letter and should know whether the change accurately reflects their current situation.  If it doesn't the employee should contact HMRC to discuss the tax code change and agree any alteration they feel is necessary.  Neither the employer nor their payroll provider can make this call to HMRC as it is a personal issue.

What do the numbers mean?

The tax code indicates how much income an individual can receive before they start paying tax.   This is their personal allowance and it is shared equally over 12 months across employed income.  The personal allowance for 2020-21 was £12,500 and for 2021-22 it is £12,570.  This creates the tax code 1250L for 2020-21 and 1257L for 2021-22.  This is know as the standard tax code which changes each time the personal allowance for the year changes.  

Employees are most likely to have the standard tax code if they have one job, no taxable benefits and no other income.  If they have a second job the second job will be taxed at basic rate - a tax code of BR - indicating that there is no tax free allowance and all income is taxable.  This is because the starter declaration they completed showed that they have another job or other income.  This ensures that they pay sufficient tax throughout the year and don't have a large bill to pay after the tax year is finished.  However if the employee has two jobs and isn't earning sufficient in one to pay tax they can ask HMRC to share their personal allowance equally across both jobs or with any other income they may have.  

If an employee hasn't paid enough tax on their income in a prior tax year they can ask for it to be collected through their PAYE tax code.  In this instance they will have a lower personal allowance and therefore a lower than standard tax code.  If they are entitled to a higher level of tax free personal allowance they will have a higher tax code.

What does the letter at the end mean?

An employee's tax code will generally have the letter L after it but it may also have W1/M1 after it.  This indicates that it is an emergency tax code and tax is calculated on the weekly or monthly earnings rather than cumulatively across the year.  HMRC may send a change to remove the W1/M1 during the year but, if not, it is automatically removed at the start of a new tax year.

The other letters which you may find at the end of the tax code are:

• M or N if they have shared or are sharing 10% of their partner's personal allowance 
• D0 if all income is taxed at higher rate 
• NT if no tax is being paid on income
• BR if all income is taxed at Basic Rate (20%)

What if there is a K at the beginning?

If an employee has a K code at the beginning of their tax code number this means that they owe tax on other income and the amount due means they do not have any personal allowance.  The K code can calculate a tax payment of up to half of the employee's  pre-tax wages.

Why are tax codes important?

It is important to understand the relevance of a tax code when processing payroll.  Whilst the majority of employees will be on the standard tax code the effect on the business of someone on a non-standard tax code could be significant in terms of cash flow. 

For example, offering an employee a guaranteed take home pay and then finding they have a K code because they owe a significant amount of tax would mean you are paying for their tax because you have to increase their gross pay significantly more than you expected in order to give them the net pay you agreed. 

Equally a new employee who hasn't worked for a few months but had significant earnings in the same tax year will be due a tax refund when they start work with you and you will have to fund that when you pay them.  This shouldn't stop you employing anyone who hasn't worked for a while but it is something to be aware of.  

Supporting your employees - and you!

Understanding tax codes is just a small part of running a payroll and helping your employees to understand the deductions from their pay.  Payroll can be as simple as pressing a button in your payroll software but explaining pay issues to your employees can be a challenge.  That is where we come in. 

We will provide you with information about any unusual changes in your employees' pay so that you can explain it to them easily if they ask you.

Just one of the ways outsourcing your payroll can make your life easier!  Contact us to find out how else we can make your life easier.