UK Tax Essentials

Tax Code – Understanding UK Income Tax

Understanding UK Income Tax – PAYE, Tax Codes And Bands

A Guide To Direct And Indirect Taxation In The UK – How To Save Money
Chapter Three

Story Highlights:

In this introduction to income tax in the UK, we’ll be looking at:

  • The history of income tax in the UK
  • What the PAYE System is
  • Understanding your payslip and why you should keep them safely
  • Where to find your tax code
  • How HMRC works out your tax code and what the number and letters mean
  • Why/When your tax code changes and how to change it
  • What to do if you’ve been given the wrong tax code
  • Your tax codes when you have two jobs
  • Income tax bands and your Personal (Tax-free) Allowance
  • Changes in tax bands and Personal Allowance for 2017-18
  • What an income tax calculator is

Tax codes and the basics of the UK income tax

We begin this first introductory chapter devoted to income tax by giving a brief history of income tax. Although it’s an inevitable part of our lives nowadays, did you know that income tax wasn’t imposed until 1799? We continue the chapter by talking about the necessity of understanding, checking and retaining your payslips in a safe place after an explanation of what the PAYE system entails.



HMRC tax codes are explained in great depth – not only what they mean but also how they’re worked out, when these tax codes are changed before giving useful advice about what to do if you’ve been mistakenly given an incorrect tax code. Do you have 2 jobs? If so, we give information about how this affects your tax codes.

Finally, we look at your Personal Allowance and tax bands in the UK – who pays no income tax and who pays 20%, 40% or 45% income tax? We have up-to-date information about changes to the tax bands and Personal Allowance for 2017-18 and give advice about how to use an income tax calculator to work out how these changes will affect you financially in the coming year.

UK income tax history

A statue of William Pitt the Younger who first introduced income tax in the UK in 1799

Believed to be an unnecessary intrusion into people’s private affairs, income tax was massively unpopular when it was first introduced in the UK in 1799 by William Pitt the Younger. It was reintroduced a year after being abolished but was given a different name to prevent public opposition. It wasn’t called income tax again until 1842 but remained controversial well into the 20th century.

First treated as revenue to fund wars (both the Napoleonic Wars & the Crimean War), it wasn’t used as a source of income to fund the very first welfare benefits until Lloyd George’s ‘People’s Budget’ of 1909. In fact, for the very first time in British history it was felt that income tax could be used as a way to redistribute wealth and help the less advantaged.

Also On Family Money…
In our dedicated article on UK income tax you will find out about your tax return, tax relief and fringe benefits in the UK. Read our article to help you understand how to file for your tax return

Both World Wars needed the number of taxpayers to be increased in order to fund military expenditure. Initial trials in 1940-41 led to the development of the PAYE (Pay-As-You-Earn) scheme across the whole of the UK in 1944. Not only was tax revenue collected more efficiently but the system was so much faster than waiting for tax payers to file a tax return at the end of the fiscal year.

Income tax was reintroduced with a different name to prevent opposition

What is the PAYE tax system?

The PAYE scheme allows employers to withhold tax on their weekly or monthly payments to their employees. These payments can be seen as advance payments of income tax and have to be sent to the Tax Office immediately. Since April 2013, these payments have been given as ‘Real Time Information’ to HMRC so possible changes can be made immediately.

The use of a tax code means that the correct amount of tax can be deducted over the year so that there is often no need for a tax return. This tax code takes account of any other income you may have and your personal circumstances so you’ll be taxed accordingly. But where can you find your tax code?

Understanding your payslip and tax code

One of the places you can find your tax code is on your payslip; every employee is entitled to an individual, detailed, written payslip – whether this is on paper or sent in electronic form. Let’s look at your payslip in more detail.

Most payslips will show your gross pay (your full salary before any deductions are made), the amount of your variable deductions (such as tax payments and National Insurance contributions), the total amount of fixed deductions (such as union dues), your net (or take-home) pay and the amount and method of payment. You’ll probably also have a record of your tax code, National Insurance number, pay rate (whether this is annually or weekly), and additional payments like overtime and bonuses. Depending on your circumstances, your payslip might also include any expenses, pension contributions and maintenance or student loan payments.

You should make a habit of regularly checking your payslip to make sure that all the details on it are accurate.

You should make a habit of regularly checking your payslip to make sure that all the details on it are accurate. If you have any queries, you should notify your employer and/or the accounts department of your workplace.

Summary:

Income tax wasn’t introduced in the UK until 1799 and it remained controversial until well into the 20th century.

The introduction of the PAYE system in the UK in 1944 allowed income tax to be collected efficiently and quickly.

The PAYE system – with its tax codes – allows income tax revenue to be collected by employers with automatic deductions which are advance tax payments.

Your payslip should be checked regularly since it gives details of all your earnings as well as any deductions which are made.

Why should I keep my payslip?

There are 3 main reasons why it’s important to keep your payslips. The first is for reasons of security – the details included in a payslip would be a mine of information for anyone wanting to commit identity fraud. The second reason why you should keep them safely is that they’re part of your financial record-keeping. If a query arises regarding your financial affairs, you’ll have evidence of how much you earned exactly. Finally, to access some financial products such as loans or even to rent a house, they often ask for your last 3 payslips as proof of your earnings.

Your payslips contain information such as your tax code and it is important to keep them safe

When disposing of all payslips, don’t just throw them in the bin intact but make sure they are totally destroyed such as by shredding them.

What is my tax code?

Apart from on your payslips, your tax code can also be found on your P45 (if you leave your job) or on your P60 (which is given at the end of the tax year).

If you have more than one source of income such as two different jobs or pensions, then you’ll also have different tax codes. Your code doesn’t say how much you earn but instead informs employers of how much tax to take from your earnings. Even if you stay in the same job, your tax code will also change every tax year since your Personal (tax-free) Allowance also changes every year.

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How does HMRC work out my tax code?

Your tax code is made up of numbers and letters. The number refers to how much income you can have before you need to start paying income tax. HMRC works this out by calculating how much income you haven’t paid tax on (such as untaxed interest) and adding this to any benefits you may have like a company car; this sum is taken away from the tax-free income you’re allowed and divided by 10.

Tax codes explained

The number in your tax code is put in front of a letter/letters and this refers to your personal circumstances. The most common letter(s) are explained below:

  • L Standard tax-free Personal Allowance
  • M Marriage Allowance – you’ve received a transfer of 10% of your partner’s Personal Allowance
  • N Marriage Allowance – you’ve transferred 10% of your Personal Allowance to your partner
  • S Your income is taxed according to the rates in Scotland
  • T HMRC uses other calculations to work out your Personal Allowance
  • OT Your Personal Allowance has been used up, you’ve started a job without a P45 or didn’t provide your employer with enough details
  • BR All income is taxed at the Basic Rate (usually for more than 1 job or pension)
  • DO All income is taxed at the Higher Rate (usually for more than 1 job or pension)
  • D1 All income is taxed at the Additional Rate (usually for more than 1 job or pension)
  • NT You aren’t paying tax on this income
  • K Other circumstances. For example, you are paying tax you owe from previous years, you’re receiving a taxable state benefit or you’re receiving workplace perks such as a company car or health insurance which you need to pay income tax on
  • W1 or M1 Non-cumulative emergency tax codes which are calculated on what you earn per week/month instead of the whole year

For more information on tax codes in the UK, you can go to this website.

Questions:

Who developed the PAYE scheme?

The PAYE scheme was devised by Sir Paul Chambers (1904-1981), a British civil servant and industrialist.

How many people are taxed using the PAYE system?

According to the IFS (Institute for Fiscal Studies), 85% of taxpayers in the UK are taxed using PAYE.

Who pays the most tax?

In May 2016, HMRC released information on which industries paid the highest amounts of income tax as a percentage of total income tax revenue. You may find the results surprising.

  1. Financial & Insurance Activities: 16.6%
  2. Professional, Scientific & Technical Activities: 10.8%
  3. Wholesale/Retail Trade & Repair of Motor Vehicles: 10.6%
  4. Manufacturing: 10.3%
  5. Human Health & Social Work: 8.7%
  6. Education: 8.1%
  7. Information & Communications: 7.6%
  8. Administrative & Support Services Activities: 5.3%
  9. Public Administration, Defence & Social Security: 4.6%
  10. Construction: 4.5%

Are tax returns a matter of public record?

Unlike some countries, tax returns in the UK are confidential. However, there’s ongoing debate about whether the tax returns of politicians or the extremely wealthy should be made freely available whilst others want all companies to reveal how much they pay in taxes.

Summary:

For reasons of security and for your own personal record-keeping, you should keep old payslips and later dispose of them properly.

Your tax code can be found on your payslip, P45 or P60.

Your tax code consists of numbers and letter(s) and is worked out according to your taxable income and your circumstances.

Reasons for changes in your tax code

Picture of a young man being promoted, who now has the responsibility to notify the tax office

Apart from changing every year when the (tax-free) Personal Allowance rises, your tax code will change when your personal circumstances change. This is why it’s vital that you let the Tax Office know immediately of any such changes. These could be when you start or stop receiving perks of your job such as a company car or work expenses for which you claim a tax rebate. If you start or stop receiving an income such as from a rental property, then HMRC should also be informed.

Changing your tax code

You can inform the HMRC personally of any changes in your circumstances or it could be done on your behalf by your employer or pension provider. Upon receipt of your notification, the Tax Office will work out your new tax code and send it to your employer so they can work out your PAYE deductions. You will also receive a PAYE Coding Notice, which will explain the changes to you.

What to do if your tax code is wrong

Having the wrong tax code can have quite serious repercussions since it means you will end up paying the wrong amount of income tax. Obviously, if you pay too much, you can apply for a rebate but what would happen if you haven’t been paying enough? Paying back taxes is much more difficult for anyone especially when you have other financial commitments to meet every month.

You will realise that your tax code is wrong if the numbers/letters don’t fit your circumstances or your payslip shows that the wrong amount of tax is being deducted. In this situation you could ask your company’s accountant to fill in a PAYE Coding Notice query form or you could contact the Tax Office in person by phone: 0300 200 3300.

Questions:

What tax code should you be on?

The tax code you should be on depends on your personal circumstances. HMRC works this out by calculating how much income you haven’t paid tax on and adding this to any benefits you may have.

How are tax codes used?

Your tax code is used to inform employers how much tax to take from your earnings. Your tax code doesn’t reveal how much you earn.

How can you change your tax code?

You could ask your company’s accountant to fill in a PAYE Coding Notice query form or you may contact the Tax Office by phone: 0300 200 3300.

What is the most common tax code in the UK?

The most commonly used tax code by taxpayers with 1 job is 1150L – the number 1150 refers to the tax-free Personal Allowance of £11,500 divided by 10.

Tax codes and working two jobs

In these times when it’s difficult to get by, you might be in a position where you have to take on a second – often part-time – job. In this case, how does the PAYE system work?

If you have 2 jobs, then your main job is used to calculate your tax code and your Personal Allowance. HMRC will then automatically apply any leftover allowance to the other job.

If you have 2 jobs, your main job is used to calculate your tax code and Personal Allowance. HMRC then automatically applies any leftover allowance to the other job.

Having a second job is one of the times when the Tax Office must be informed since you could end up paying too much or too little income tax. If the combined salaries of both jobs is less than your Personal Allowance, you’ll pay too much tax. On the other hand, if your combined earnings make you a Higher-Rate taxpayer but you’re taxed at the Basic Rate, you’ll be in for shock at the end of the tax year when you have to pay all the back taxes. Having 2 jobs means that you’ll also have 2 different tax codes.

UK income tax bands

The rate at which you pay income tax in the UK depends on how much you earn from your job or other possible sources of income. The higher your salary, the higher your income tax. Below are the changes in the tax bands for the 2017-18 fiscal year:

Personal Allowance Up to £11,500 0%
Basic Rate £11,501-£45,000 20%
Higher Rate £45,001-£150,000 40%
Additional Rate Over £150,000 45%

Your Personal Allowance is the amount that you’re allowed to earn before being taxed. To take an example, someone who earns £45,000 a year won’t be taxed on the full amount since their Personal Allowance must first be deducted so they will actually pay income tax on the sum of £33,500.

Changes in UK personal allowance and tax bands 2017-18

If you refer to your Personal Allowance for 2016-17, you will see that the tax bands have been increased. The Personal Allowance used to be £11,000 while the Basic Rate limit was £43,000.

This is part of a series of changes made by the British government to reduce income tax for many taxpayers. In a statement announcing these changes, they said that increasing the tax bands would be an incentive to work, increase people’s disposable income and encourage both higher consumption and savings. They estimate that 28.9 million British taxpayers would pay less income tax in the coming fiscal year.

Questions:

When does the UK tax year run?

The UK tax year runs from 6th April – 5th April so on your payslip April is counted as month 1 (so March is month 12 for the purposes of tax).

How many UK taxpayers are men compared to women?

According to HMRC, for the 2017-18 tax year, 58% of taxpayers are men and 42% are women.

How many people in the UK don’t earn enough to pay income tax?

According to IFS statistics for 2016, around 43.8% of working-age adults in the UK don’t earn enough to pay income tax.

How will the changes in tax bands affect taxpayers in 2017-18?

According to government estimates, 424,000 people will no longer have to pay tax. 24.1 million people in the Basic Rate will have average gains of £56, 4.5 million taxpayers in the Higher Rate band will find themselves on average £233 better off while those in the Additional Rate will save £110 on their income tax payments.

How does HMRC calculate the increases in taxpayers’ tax-free Personal Allowance?

Changes in the tax bands and the Personal Allowance are usually announced at the time of the annual Budget. These increases are kept in line with the percentage increase in the CPI (Consumer Prices Index) in the year up to the previous September.



Summary:

You should tell the Tax Office of all and any changes in your circumstances since your tax code may have to be changed accordingly.

You can inform the Tax Office of changes in your circumstances or your employer/pension provider can do it on your behalf.

If you think you’ve been allocated the wrong tax code, you should query this immediately as you might end up paying too much/little income tax.

The tax authorities should be informed if you have 2 jobs to allocate 2 different tax codes so your PAYE deductions are accurate.

There are different tax bands in the UK depending on your income and these have been increased in the 2017-18 tax year.

What is an income tax calculator?

In view of the recent increases in the tax bands and the Personal Allowance, you might be wondering how these changes will affect you personally and your own take-home pay.

Online income tax calculators are ideal to use if you have one source of income

Online you’ll find many income tax calculators, which are extremely simple to use. All you have to do is enter your annual gross pay and it will be able to calculate how much salary you will receive each month (with deductions) and how much your PAYE contributions will be. In this way, you’ll be able to see how much you’ll benefit in the 2017-18 tax year.

Such calculators are ideal to use if you have one source of income from employment which makes your tax contributions easy to work out. For taxpayers whose financial affairs are more complicated such as the self-employed, these income tax calculators are less accurate.


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About the author

Thomas Henderson

Thomas worked as a consultant in personal finance in the UK for 18 years. He has found a passion in sharing his experience on familymoney.co.uk

Thomas also takes pleasure in woodworking, reading and observing stock market trends.

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About The Author

Thomas Henderson

Thomas worked as a consultant in personal finance in the UK for 18 years. He has found a passion in sharing his experience on familymoney.co.uk

Thomas also takes pleasure in woodworking, reading and observing stock market trends.

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