Are you paying too much tax? We unravel the mysteries of PAYE codes.
Last week, HM Revenue and Customs announced that they will start charging interest and penalties on late paid PAYE payments. But don't worry, they are not targeting your average Fool with this new approach, this is aimed at those scurrilous employers who happily deduct the relevant tax and National Insurance from your wages, but then, somehow, fail to pay over this cash to HMRC on time.
Pay as you Earn, or PAYE was introduced to make income tax payment and collection easier for the huge percentage of employed taxpayers in the UK. Assuming your PAYE notice of coding works as it should, you should never face a large tax bill, or a large tax repayment, at the end of any given tax year.
However, PAYE codes are woefully misunderstood by most people, and even many accountants. If you do not know if your code is right or wrong, how can you advise HMRC when it needs changing to avoid that potential hefty bill.
The basics
PAYE codes are normally comprised of three numbers either preceded by or succeeded by a letter. The exceptions to these are NT (0% tax), BR (basic rate/20% tax) and D0 (40% tax). Whether these will be joined by ST for the 'supertax' rate of 50% in 2010 remains to be seen.
Adding a '5' to the end of the three numbers equates to the tax-free allowance applied to your earnings, for example, if your notice of coding reads 643L, your tax-free allowance is £6,435, if 240T, then your allowance is £2,405. Simple.
The letter used does not really matter for the purposes of deciphering your tax code unless that letter is a K. K codes are prefixes and instead of ensuring you benefit from a tax-free allowance, these codes add notional extra income to your salary to make sure you pay more tax on a monthly or weekly basis.
The calculation
The standard tax code for 2009/10 is 647L, which equals the normal personal allowance of £6,475 per annum. If your tax code is not 647L this does not mean that you are being cheated out of your personal allowance (or necessarily getting more, as you can have tax codes in excess of 647), it is all down to the calculation.
When HMRC send you the notification of your tax code, you should receive a document with two large boxes near the top. On one side are your allowances and the other side is for deductions. The easiest way to imagine the system is as a set of scales.
On the allowances side everyone (up to 2009/10 at least!) will start with 6,475. To this side will be added any extra allowances due, such as additional age related allowances for those over 65/75 or blind person's allowance.
So far so good. Other things that might appear on this side are specific items that you may deduct from your income on your personal tax return. A good example of this would be a professional subscription that you pay yourself (rather than claiming as an expense from your employer).
Now for the other side. The most common deductions seen are for benefits in kind. If you have received a benefit for one tax year, it is assumed you will receive the same benefits in future so things like company car benefits or private medical insurance will be included here to weigh down your deductions side, thereby reducing your allowances.
Other things that are often seen are small sources of untaxed income. Things like a state pension or gross bank interest or rental income, provided they are small when considering the employment income, can be added here, meaning you effectively pay the tax liability arising on these untaxed sources monthly through your pay packet instead of in a lump sum at the end of the year.
The final thing that will often appear here are adjustments. Certain adjustments are obvious -- if you have chosen to carry forward a previous tax bill to pay by PAYE, this will show here; similarly HMRC may insert estimated underpayments if they have become aware of a change in circumstances part way through a year. Note that a £100 underpayment will not be collected by a £100 deduction in you notice of coding. If your marginal rate of tax is 20%, the restriction in your coding will need to be £500 (100/20%) in order to increase the tax collected by £100.
Other adjustments may be more complicated. Certain age allowances, for example, are phased out once income exceeds certain levels. From 2010, the reduction and removal of the standard personal allowance for those earning over £100,000 is likely to appear here.
The weighing up
Once all allowances and deductions are included, the net answer is your tax code. If the number is positive, a suffix code will arise. If negative (i.e. deductions exceed allowances), the last number is reduced by one and a K code ensures the extra tax due will be collected.
So how do you check your code? Well, you need to see whether the numbers included by HMRC are correct and reasonable. If your code shows subscriptions that you no longer pay, or underestimates the value of your car benefit, you will likely have to pay a lump sum at the end of the year, and remember, under Self Assessment it is your responsibility to tell HMRC when you have underpaid tax or face the (potential) penalties.
Better PAYE up!
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