The HMRC have recently released a tool to help UK taxpayers understand what their tax code means. Inspired by this development I’ve decided that this week we will be discussing tax codes. Across all of our businesses there is nearly uniform agreement that the way the HMRC operate tax codes is confusing, demoralising, and sometimes just wrong.
With the information presented here you will now get a full understanding of what your tax code means, and how you can have it changed if you think you are on the wrong tax code.
This article is relevant for PAYE employees, umbrella workers, and limited company contractors. Actually, pretty much anyone who earns an income and is taxed in the UK will have an interest in understanding how their tax code works.
Want to watch our YouTube video instead? It summarises the main points but refer back to this article for more in-depth information.
What is a Tax Code Used For?
A tax code is used by the HMRC as a means for collecting tax or refunding tax to taxpayers. This is a bit of an oversimplification because there are other means that the HMRC can use to do this but if you step back and look at the overall tax code system, its purpose is to ensure that taxpayers pay the correct amount of tax on their income.
One way of determining that you are always paying the correct amount of income tax is to complete a personal tax return every year. For a very large number of taxpayers this introduces an element of complexity and administration because completing a tax return may feel overwhelming for a lot of people and there are of course filing deadlines and penalties which need to be considered.
The tax code system is in place to ensure taxpayers can pay the right amount of income tax without having to complete a personal tax return.
There are lots of reasons why your tax code may be changed, and the most common two are;
(1) You receive untaxed income such as dividends;
(2) You owe (or are owed) tax from previous years;
What Happens When My Tax Code Changes
When the HMRC have decided that your tax code needs to be changed, they will send a tax coding notice to your employer to advise them of your new tax code.
When your employer adds your new tax code to their payroll software, there will be a new calculation for the amount of PAYE that will be deducted from your next payslip.
So when there is a change in your tax code this will affect your payslip calculation and will decrease (or increase) your net pay for the pay.
How Can I Tell If They Have It Wrong?
Remember your PAYE tax code is used as a tool by the HMRC to collect extra tax off you (or to give you a tax refund). If the tax code has been worked out correctly then this is a nice way of ensuring your tax affairs are kept in order.
But the HMRC do not always get it right. In fact in our experience they frequently get it wrong. Fortunately they share the details of their calculation with you so you can determine if their calculations and assumptions are correct, or if they have in fact issued you with the wrong tax code.
The calculation for your tax code itself a straightforward and simply relies on your anticipated income for the current tax year from all sources. Lets say you are in a full-time role earning £60,000 per year, and that you have no other sources of income from anywhere else. If you were to get a notice of a tax code change then take a look at the calculation the HMRC have used to determine what tax code you should be on. For example the HMRC tax code calculation may have glitched and they might have based the calculation on an annual salary of £82,250, dividend income of £5,000, and foreign income of £3,500.
In the above scenario your revised tax code would mean that a higher amount of PAYE is getting deducted from your monthly salary because the HMRC think they have found two sources of untaxed income (dividends and foreign income). In cases like this you would just contact the HMRC asking them to update their tax code calculation based on your actual earnings for the current tax year. Once that is being processed by the HMRC they will issue you with a new tax code (usually within a week or so).
What Does a 1257L Tax Code Mean?
A tax code of 1257L is the most common code for both the 2022/23 and 2023/24 tax years. If you only have one job and no other sources of untaxed income then this will be your tax code for the 2023/24 tax year. This default tax code for the year is often referred to as the emergency tax code.
For the 2023/24 tax year, if all of your income is taxed through the PAYE tax system and if you don’t owe the tax office any money (and if they don’t owe you anything) then a tax code of 1257L is absolutely the correct tax code to be on. It means you are getting full use of your personal allowance and that your employer is making the correct tax deductions for you.
What does my tax code mean?
Your tax code is just a bunch of numbers and letters but there is method to the madness of how your tax code is formatted. We’ll quickly run you through these now.
One Off Formats
There are a group of tax codes that don’t meet the usual formatting requirements. These tax codes by themselves have a special meaning. Note that the codes vary depending on if your employer is based in (a) England or Northern Ireland (b) Wales (c) Scotland, but they all mean very similar things and for the purposes of this article I will just focus on the England or Northern Ireland tax code formats.
BR – this tax code will tax all of your income at the basic rate (20%), regardless of how much you earn. It’s typically used for a second job or pension income.
D0 – similar to BR above except this will tax all of your income at the higher rate (40%)
D1 – similar to BR and D0 above except this will tax all of your income at the additional rate (45%) – ouch!
0T – this tax code will tax all of your income at the usual tax bands except it will completely disregard your personal allowance. This is typically used where there is not enough detail to work out if you have already used up your personal allowance with other income for the same tax year.
NT – this tax code will not tax any of your income at all. This tax code only applies in very specific situations, for example where you receive a salary from a UK employer where you are not a tax resident of the UK and where you are residing in a country that operates a double taxation agreement with the UK.
Starting with the letter ‘K’
Some tax codes start with the letter K. For most people this happens when (a) they owe income tax from a previous year (b) or are getting company benefits or state benefits that they need to pay tax on where those benefits exceed the tax free personal allowance. Let me give you a simplified example of getting a K tax code.
Last week Jen was paid $600 per week on the usual 1257L tax code. She gets £242 of weekly tax-free income, and so pays 20% tax on 600 – 242 = £358. Her weekly PAYE was 358 x 20% = £71.60.
This week Jen gets a company car with an annual taxable value of £15,170 added to her employment package. This exceeds her personal allowance by 15,170 – 12,570 = 2,600. The HMRC would now put her on a K tax code because they need to collect the tax on this benefit she is now getting. In this case her new code with be K260. Jen now pays the normal tax on her £600 per week income, ALONG with tax on her new company car benefit. Her weekly PAYE is now £130 because her weekly taxable income has now effectively increased by 15,170 / 52 = £292.
The Numbers Part of Your Tax Code
Unless your tax code starts with K, the numbers part of your tax code refers to the amount of tax free income you can earn before the usual tax bands start to apply. The digits of your tax code represents the first four numbers of your annual tax free allowance. For example if your annual tax free allowance is £12,570 then the digits part of your tax code will be 1257. You effectively just take your tax free earnings and divide by 10.
Letters at the End of Your Code
Usually your tax code will finish with the letter “L” but there are other letters that are used which represent different things. I will cover them off quickly here;
L – Most commonly used, this calculates your tax based on the usual tax bands and assuming that you are entitled to the tax free personal allowance.
N – similar to the above, it calculates your tax based on the usual tax bands but is used where the employee has received some personal allowance from their spouse or civil partner.
M – similar to the above, it calculates your tax based on the usual tax bands but is used where the employee has transferred some personal allowance to their spouse or civil partner.
T – works the same as “L” above except the T marker indicates that the HMRC are reviewing some of the income items with the employee.
W1 or M1 at the End
W1 (week 1) and M1 (month 1) are emergency tax codes and appear at the end of your tax code, for example ‘1257L W1’ or ‘1257L M1’.
These W1/Mth1 markers are often a great source of confusion and that is because of the nature of how tax codes work. Your tax code is either Cumulative or W1/Mth1. The Wk1/Mth1 tax code suffix tends to be used when the HMRC are a little unsure of what your tax code should be. This may be because you have had different employments over the course of the year.
A cumulative tax code calculates your tax due based on all of your earnings to date for the current tax year. A Wk1/Mth1 tax code treats each pay period as its own distinct payroll and ignores any previous payroll calculations for the same tax year.
Let’s do an example to help you understand this.
Jen is paid £600 per week and is on the usual 1257L tax code. Because the tax code does not include Wk1/Mth1 at the end of it, then we know this is a cumulative tax code.
In Week 1 Jen gets £242 of weekly tax-free income, and so pays 20% tax on 600 – 242 = £358. Her weekly PAYE was 358 x 20% = £71.60.
In Week 2 Jen gets £242 of weekly tax-free income, and so pays 20% tax on 600 – 242 = £358. Her weekly PAYE was 358 x 20% = £71.60.
In Week 3 Jen takes unpaid leave and is not paid.
In Week 4 Jen gets £484 of weekly tax-free income because she gets to use the tax free threshold from both Week 3 and Week 4, and so pays 20% tax on 600 – 484 = £116. Her weekly PAYE was 116 x 20% = £23.20.
This is the benefit from being on a cumulative tax code. If you miss any weeks of pay, or if you receive less pay or more pay for the pay period, the tax calculation is constantly correct because it is always based on your cumulative income and tax to date.
If Jen was on the 1257L Wk1/Mth1 tax code, then Weeks 1, 2 & 3, would all look exactly the same as above. However the tax she would pay in week 4 would be £71.60. As I mentioned above when you have a Wk1/Mth1 tax code, each pay run is treated as its own separate entity and so any cumulative effects are ignored. Usually this type of tax code results in you being over-taxed which makes a cumulative tax code much more appealing.
The HMRC has released a tool to help taxpayers understand their tax codes. While its aim is to help employees better understand their tax code, I wanted to write an article to add a bit more meat to the bones because this tends to be a very confusing subject for our clients.
A tax code is used to determine the correct amount of tax to be paid without the need for a personal tax return, and if a tax code changes, it affects the PAYE deducted from the employees’ pay. Incorrect tax codes can be challenged through contacting HMRC who calculate tax codes based on anticipated income for the year.
In this article we have covered all the different formats you can expect to see in your tax code. While there are a number of different elements, the key parts to your tax code are (a) whether there is a K at the front, (b) the numeric element (c) and whether it’s a Wk1/Mth1 tax code.