One of the most challenging parts of accounting for business owners is understanding tax codes. Thanks to automated accounting software, complicated calculations and expense reports require fewer mathematical skills than ever before, but tax codes are a never-ending source of confusion for thousands of professionals across the UK.
Despite there being so many tax codes in existence, understanding how they impact you and your financial situation doesn’t have to be difficult. This blog will break down tax codes into easily-understandable segments, helping you to determine which code applies to your unique situation and how.
An overview of tax codes
So, what are tax codes? Essentially, they are made up of letters and numbers and are used by HMRC to deduct the right amount of tax and national insurance from your income. The code will also determine your personal allowance (the amount of income you can earn before being taxed).
Employees rarely have to worry about their tax code, as their employer should provide them with this information when they start work. HMRC will usually generate a tax code for every employee registered for PAYE. Businesses, on the other hand, must cultivate a deeper understanding of tax codes to ensure their accounting and payroll processes run smoothly.
However, it’s always beneficial for everyone to understand tax codes, no matter their employment status, so they can understand when they may have been under or overtaxed.
Determining your tax code
It can be hard to work out what your tax code should be as it’s based on so many different factors. Remember that your tax code may be different from another employee’s, even if they’re doing the same job as you, as there may be other circumstances impacting the amount of tax they need to pay.
If you’re employed through PAYE, HMRC will usually send you a tax code notice each year that explains what your tax code means and why it’s been assigned to you. You can contact HMRC if you don’t know your tax code or believe you may have been assigned the wrong one. Failing to contact HMRC about a mistake may mean you end up paying too much tax, or too little, which could impact your finances in the current and coming years.
Factors that are used to determine your tax code include:
- Total income from one or more sources of employment
- Taxable benefits from your employer such as accommodation or a company car
- Your yearly personal allowance
- Estimated non-taxable income
- Any tax refunds you may qualify for
What do the letters in tax codes mean?
The best way to understand the variation in tax codes is to know what each component means on a basic level. Take a look at the following list for an overview of what the letters in your tax code might indicate:
- L – Your personal allowance is the standard £12,570 threshold
- M – When one-half of a married couple receives 10% of their spouse’s allowance
- N – When one-half of a married couple transfers 10% of their allowance to their spouse
- T – Your personal allowance must be determined by additional calculations
- 0T – You have used up your personal allowance OR your employer does not have sufficient information to provide you with a tax code (typically seen at the start of a new job)
- BR – All of your income from your current job will be taxed at the basic rate of 20%
- D0 – All of your income from your current job will be taxed at the higher rate of 40%
- D1 – All of your income from your current job will be taxed at the additional rate of 50%
- NT – This income will not be taxed
- S – Your income will be taxed according to Scottish rates
- C – Your income will be taxed according to Welsh rates
- K – The amount of tax you owe to HMRC from previous years is greater than your current year’s personal allowance.
Numbers in tax codes: Explained
Now that you have a better understanding of tax code letters, it’s time to delve into numbers, which are even more straightforward. Almost every letter above will be preceded by a number that represents your personal allowance when multiplied by ten. This means that employees with the standard personal allowance will typically have the tax code 1257L, as the basic personal allowance for this tax year is £12,570.
What are emergency tax codes?
You may have heard the term ‘emergency tax code’ used before but may have been unclear on its meaning. Many employees are assigned an emergency tax code for a variety of reasons, which may include:
- Becoming employed for the very first time
- Starting a job without a P45
- Beginning PAYE employment after a period of self-employment
- Receiving company benefits or the state pension
Essentially, emergency tax codes are assigned to individuals when HMRC is unsure what code they should be on, usually due to a lack of information about their income. Emergency tax codes mean that tax can still be collected and allow HMRC to have extra time to assign the correct tax code to the person in question. Emergency tax codes are usually either 1257 W1, 1257 M1, or 1257 X.
Check your tax code today
If you suspect your tax code may be incorrect then it’s important to contact HMRC and inform them of the potential issue as soon as possible. If you have paid too much or too little tax, your tax code for the following tax year may be amended to balance out the amount you’ve paid. However, you may also be offered a one-off tax rebate that you can claim as a cheque, or you may be asked to make payments towards any tax you owe on a monthly basis.