The general perception amongst the public is that tax can be quite scary; however, we at PayFit believe that it can be easily explained and that it really is nothing to fear!
Most of us will have looked at one of our payslips and thought to ourselves, maybe even exclaimed out loud, “I swear I didn’t pay that much tax last month!!” Well, the chances are, we probably didn’t.
Taxation is convoluted and complicated, and most of us prefer not to delve too much into its intricacies. Nevertheless, it’s a necessity for any modern and well-governed society and it would probably be beneficial if we all took a little more interest in the subject.
"Nothing is certain in life except death and taxes."
We’ll start by explaining tax codes and how they influence how much tax someone pays.
All English tax codes are composed by numbers and suffixed with a letter; in Scotland and Wales, the same tax code will be prefixed by either S (for Scotland) or C (for Wales).
The numbers within someone’s tax code relate to the amount of tax free personal allowance (PA) that they are entitled to within that particular job throughout the tax year.
One of the most common tax codes in England throughout the 2019/20 tax year, was 1250L. This means that within one particular job or pension, someone’s PA was £12,500 for the tax year.
To put it simply, the numbers within someone’s tax code relate to the amount of PA that person is entitled to throughout the year for that employment or pension - e.g. a 609T tax code would mean that a person receives a PA of £6,090 and 1375M would mean a PA of £13,750 and so on and so forth.
So, now that we understand what the numbers mean, we can begin to look at the letters. As we’ve already established, letters can be both a prefix and a suffix in a tax code.
In the UK as a whole, there are several different tax categories depending on the combination of prefixes and suffixes. Furthermore, all tax codes can potentially be suffixed with an M1, W1 or X to indicate that it is an emergency tax code.
Changes to a tax code
Someone’s circumstances may change throughout the year which could lead to a change in the rate of tax.
Most people will have cumulative tax codes; these are the easiest to identify as they do not include ‘W1’, ‘M1’, or ‘X’. If a tax code is suffixed by any of these, it is considered to be an “emergency tax code”.
- A cumulative tax code calculates someone’s total tax based on their overall year-to-date earnings and tax paid.
- An emergency tax code only looks at the current month’s earnings and treat it as if it were the first period of the tax year.
Someone who has an emergency tax code will not benefit from any accumulated personal allowance, nor will they be liable to any under or overpayments of tax and they are also more likely to be hit by a higher tax threshold.
How much tax do people pay?
The tax rates and thresholds for Scotland, England and Wales are independent of each other. However, at point of writing, the current Welsh rates and thresholds are the same as those in place in England.
To establish what percentage of tax has to be paid, it is important to work out how much of someone's earnings fall into each tax bracket. The tax rates and thresholds for tax year 2019/20 are as follows:
UK tax rates.
A simple way of explaining the process is to take Jane's example.
Jane lives and works in London and earns exactly £60,000 a year. Her tax code is 1250L, which means that she has a PA of £12,500.
The above table helps explain how Jane's earnings are split over the whole tax year.
① Because her tax code is 1250L, the first £12,500 she earns are tax free
② The following £37,500 she earns are taxed at 20%
③ The next £10,000 are taxed at 40%
Over and underpaying tax
How many of us have received a letter (a P800) through the post and feared instantly that it was going to be the taxman asking for more money? When that happens, it’s pretty annoying!
However, how many of us have received a letter, also called a P800, through the post and been pleasantly surprised to see that it’s a tax rebate? When that happens, it’s pretty nice!
While this is a relatively common occurrence, HMRC do their level best to avoid this happening. Typically, if an employee has over or underpaid in a previous month, a cumulative tax code will correct this. This means that if an overpayment or underpayment has occurred, the person affected will likely pay either more or less tax the following month providing it is still the same tax year.
Processing corrections like this minimises the likelihood of HMRC approaching someone at the end of the tax year to recoup owed tax. It also reduces the delay for someone expecting a tax refund.
Notes for underpaying tax:
- If the amount owed by someone is less than £3,000, HMRC will adjust their tax code in the next tax year in order to ensure that they can reclaim the correct amount.
- If the amount is £3,000 or more, HMRC will contact someone regarding the ways that they can repay the outstanding amount.
The P45 is a PAYE form that someone will receive from an employer when they stop working for them.
If a new employee provides their employer with a P45, it will contain previous pay and tax figures if they were on a cumulative tax code. Just as in the preceding section which referred to under and overpayments of tax processing, a P45 will lead to the employee’s tax position being recalculated.
In the majority of instances, there will be no change for the employee, but if the P45 figures show an under or overpayment of tax, then this will be amended in the next payroll.
Want to find out more about PAYE forms? Check out our article here.
A change in earnings
Each month an employee's tax calculation takes into account the year to date earnings for that tax year, up to that month.
In the event that someone’s pay changes, they may be liable to paying either less or more tax. For example, if an employee works overtime or receives a bonus or increase in pay, then they may see an increase in their taxable pay. Alternatively, if a person who is earning enough to pay a higher rate of tax, suddenly sees a decrease in the amount of money they earn, they may be liable to receive a tax rebate.
Employees who earn over £100,000 need to be aware that their PA will be affected. For every £2 they earn above £100,000, they lose £1 from their PA. If they predict their earnings will surpass this amount, then they should contact HMRC and ask them to review their tax code.
The regulatory limit
The regulatory limit is set by HMRC is in place to put a cap on the amount of tax that can be deducted from an employee, particularly if an employee owes tax from previous months.
The limit set means that an employee can be deducted no more than the equivalent of 50% of their gross pay. This means that an employee whose gross pay is £2,000 will pay a maximum of £1,000 in total deductions that month.
🎤 💥 Myth-busting
Income tax only becomes payable once an employee has reached their annual PA threshold.
The annual PA is divided by the number of pay periods the employee is paid over. For example, if an employee is paid monthly, each month they are entitled to 1/12th of their annual PA, which accumulates as the months go by if they’re on a cumulative tax code. Any earnings that exceed this amount are taxable.
An employer knows why a tax code has been applied to an employee.
An employer does not find out why an employee's tax code is what it is. This is due to HMRC protecting the employee's data. Tax codes are influenced by more than just payroll earnings, so if an employee is unsure why their tax code has changed they must contact HMRC to find out.
An employer can intervene if an employee thinks their tax code is incorrect.
If an employee thinks their tax code is incorrect then they must get in touch with HMRC to resolve this with them directly. An employer can only apply a change in tax code upon receipt of the correct notices from HMRC and not on the word of the employee.
HMRC is responsible for monitoring someone's tax and tax code to ensure the correct payments are made.
HMRC can only understand someone's tax position from the figures they receive. Therefore, it is the responsibility of individuals to monitor any changes to benefits and earnings (in and outside of employment) to ensure that they are correct. If someone is unsure then they should contact HMRC immediately.
To sum up...
While tax may be the bane of many people’s lives, it’s important to remember that it’s a necessary evil.
It’s also valuable to be able to understand what the tax code on a payslip means and the reasons as to why someone is taxed the way they are.
🤔 Want to find out more?
If you're an employer and would like to find out how we at PayFit can support you with your payroll processes, then why not book a demo with one of our product specialists today?