Cracking The Code

A common misconception is that the employer determines the tax withheld on an employee’s salary each month. This is not true. Instead, tax is withheld based on a tax code issued by HMRC. This code is sent to the employer or pension provider who use this to calculate how much income tax should be withheld based on an employee’s earnings.

 

Understanding Tax Codes

Each code consists of a letter and a number which have specific meanings. The number represents how much income is tax-free or how much additional income needs to be taxed each year. It is important to note that the number in the tax code is abbreviated and should be multiplied by 10.

The letter in the code denotes whether the above number is tax-free income or additional taxable income. The most common letters are L & K. An L means there is tax-free income. A K means there is taxable income.

Here are a few examples of common tax codes:

 

  • 1257L – This code tells us that there is £12,570 of tax-free income for the tax year. This represents the Personal Allowance which is available to most taxpayers who earn under £100,000. Once they start to earn over that amount, they start to lose their entitlement to this allowance. And if they earn over £125,140, there is no allowance available at all.
    The number can vary depending on how much personal allowance is available and whether there are any other taxable items that have been included in the tax code.

*COMMON PROBLEM* – HMRC are not aware of an employee’s salary or personal circumstances so they will not update the tax code automatically if they start to earn over £100k. This often leads to a large tax payment due on the first tax return where an individual earns over that amount. To avoid this issue, they could change their tax code during the tax year. More information on changing codes is below.

 

  • 0T – This code is used for taxpayers who have no personal allowance available and there are no additional sources of income on which the employer is required to withhold tax. A common example of when this should be used is if the taxpayer earned over £125,140 or they are claiming the Remittance Basis.

 

  • K512 – This means that there is £5,120 of additional taxable income. Again, the number can vary depending on how much additional income there is or whether there is any personal allowance available. Taxable items in a tax code generally include:
    • Employee benefits not reported via payroll e.g. medical insurance or a company car
    • State benefits such as state pension
    • Unpaid tax from an earlier year

 

  • BR / D0 / D1 – these instruct the employer to withhold tax at a flat 20%, 40% or 45% respectively, with no allowances or other taxable items.
    These tax codes are commonly used if the employee has more than one employment (or pension). One employment would receive an ordinary code (e.g. 1257L) which would utilise available allowances. The second employment would receive a BR, D0 or D1 code to avoid double counting the personal allowance and lower tax brackets.

*COMMON PROBLEM* – these codes can lead to significant under or overpayments of tax if not applied correctly. It is important that these flat rate tax codes are applied to the smaller employment or pension and the ordinary code is issued to the main source of income. It is quite common for HMRC to incorrectly issue these codes when there is a change of employment. If that is the case, the employee should have this updated immediately to avoid any surprises at the end of the tax year.

 

  • M1 / W1 / X – these are emergency tax codes and are applied when full details of an employee’s income are not available.
    An ordinary tax code, such as 1257L, will apply the personal allowance to each working month in the tax year taking into account how much allowance has been utilised and how much taxable income has been reported already. An M1 code will not factor in any personal allowance or salary previously reported and will apply a flat 1/12th of all allowances and tax rates.

*COMMON PROBLEM* – M1 codes are nearly always incorrect and usually result in over-withheld tax. This can usually be avoided by providing the employer with a P45 from the previous employer.

 

Changing codes

HMRC will update a tax code based on information they have available. Generally, this will be the most recent tax return submitted by the taxpayer which means the tax code may not always be relevant to the current tax year. It is important to make HMRC aware of any changes in circumstances so that the correct code can be issued at the earliest possible opportunity.

This can be done by Contacting HMRC directly or via a tax preparer if they are authorised as the employee’s agent with HMRC.

There are also further options available via the Government Gateway.

*COMMON PROBLEM* – If the code is changed in the year, the remaining payments will be adjusted so that the code had applied for the full tax year. If an incorrect code is changed late in the tax year, e.g. from 1257L to 0T, the under-withheld tax will need to be collected in the remaining months which can affect the net salary amount. In this instance, it may be worth calculating the additional tax with your tax return which gives the taxpayer until 31 Jan in the following year to settle the unpaid tax.

 

The information contained in this article is not tax advice. Please contact us directly for more information on your personal situation.