Everyone has a tax code, even if they do not know what it is or one has not been specifically advised by the Revenue. A tax code tells an employer how to calculate the tax to be deducted under PAYE. It will not necessarily determine the correct amount of tax owed by an employee on his or her gross pay during the year, but in most cases it will do.
A tax code normally consists of a 3 digit number followed by a letter. The number will represent roughly 10% of the total free pay allowed for that employee during the tax year. Free pay normally represents the personal allowance in force for that year, so for 2009/10 the standard tax code is 647L, representing the personal allowance of £6,475. However, it may be higher or lower than this depending on the individual circumstances of the taxpayer.
Employees with personal pension plans who are on higher rate tax should get a higher tax code to allow them additional tax relief on their pension contributions. Conversely, employees on higher rate tax may be given a lower tax code in order to collect the additional tax payable on their investment income. And employees receiving benefits in kind will almost always get a lower tax code to allow for the tax due on the benefit. This system avoids the need in most cases for such employees to file an annual tax return, but tax codes are of necessity based on estimates, so it still wise to check that the right amount of tax has been deducted each year. If you do owe tax and are not sent a self-assessment tax return you are obliged by law to request one, even if it was due to your tax code being wrong. And it is surprising how often you can pay too much tax under PAYE. You are unlikely to get a rebate unless you ask for one!
The amount of tax to be deducted under a particular code is based on published Pay Adjustment Tables. These show the amount of free pay to allow based on the tax code and the PAYE period. This is usually a two-step process as the tax tables only go up to 500. For example, the free pay figure in October 2009 for someone with a 647L tax code would be £3,779.44 based on a fixed figure of £2,916.69 for the first 500 plus £862.75 for 147. Of course, any software package you use to do your payroll will calculate free pay automatically. It should only be necessary to look up free pay for individual tax codes if you are using spreadsheets or manual methods, in which case your tax code tables will probably be getting a bit dog-eared by now!
Tax is normally worked out on a cumulative basis. This means that you first calculate tax on an employee's taxable pay for the year to date (not on taxable pay for the current week or month) and you then deduct the cumulative tax for the previous week or month. This leaves you with the tax for the current week or month, and if there have been no changes in either gross pay or the tax code, the tax to be deducted should be the same as it was last time. However, some tax codes are issued on a W1/M1 basis. This stands for Week 1 Month 1, and means that the tax code is non-cumulative. You only base it on free pay for that code in the first week or month of the tax year and deduct it from gross pay for the current week or month in order to arrive at taxable pay. You do not deduct cumulative tax for the previous period. W1/M1 codes are only usually issued for new starters where there has been a break in employment of at least 4 weeks and the Revenue have already given a tax rebate. Employers must also use a non-cumulative code if the employee signs a P46 and states that he/she has already had a job or been claiming benefits since the start of that tax year. It is important to ensure that tax is calculated correctly when an employee switches from a cumulative to a non-cumulative code, or vice versa. Generally, you will only implement the change from the date the new tax code is issued and not adjust tax deducted in previous periods retrospectively.
The suffix is normally irrelevant to the taxpayer or employer. The usual one is L. Pensioner tax codes will be P or Y depending on their age. Those aged 75 or more get a higher personal allowance but that will be reflected in the number anyway. T means that there are items in your tax code that they need to review. Normally this is a temporary code that is soon replaced by another tax code. The only letters that are relevant for tax purposes are NT, BR, DO and K.
NT means No Tax so effectively the employer should simply stop deducting tax from that point onwards. BR means that no free pay is allowed and all pay is to be taxed at the basic rate, currently 20%. This should only apply if you have more than one job and your tax code is already used for your main job. DO is the same except that tax must be deducted at the higher rate, currently 40%. When the new 50% rate is introduced in April 2010 there will need to be a special suffix for that too.
K codes are a bit more complicated. These only apply if the Revenue thinks that the taxpayer will owe so much tax on benefits in kind or on investment income that no free pay should be given at all. A K code is a bit like free pay in reverse. It means that instead of deducting free pay your employer will add on an amount to gross pay and tax that as well. However, there is a limit on how much tax they can deduct in any one week or month. If you are given a K code, your employer cannot deduct more than 50% of your total gross pay.
You will normally receive a PAYE Coding Notice at least once a year telling you how your code has been calculated. At the same time, your employer will receive a less detailed notice informing them of what tax code to use without any information showing them how it has been calculated. However, sometimes your employer will have to use an emergency code. This is equivalent to the standard tax code each year and normally only applies if you have started a job without giving your employer a P45. You will then have to sign a P46 instead and the emergency code will be cumulative or non-cumulative depending on which box you tick describing your circumstances. It may even be BR if you state that it is not your only or main job.
The Revenue will normally advise employers of which code to use for an employee during a particular tax year on Form P9. However, these are not issued for very employee. They are usually only issued if there has been a change of some kind. If a P9 is not issued, the employer is expected to simply amend the final tax code for the previous year in line with the increase in the personal allowance announced in the Budget. If there are any changes to a tax code during the tax year, the employer will be notified on Form P6. These forms are now issued on-line rather than on paper to those employers who have chosen to receive them this way, so it is important to check your PAYE On-Line Services regularly for any communications. It is also important to forward tax code notices to your agent if you have out-sourced your payroll or make sure they receive the communications on your behalf.
It may sometimes be necessary to give an employee a tax rebate if they have paid too much tax in a current or previous employment. This may happen with lower paid employees whose earnings are only slightly higher than their free pay. However, rebates should not be given to new starters for tax deducted in previous employments unless the employee gives you a P45 with a cumulative tax code or you subsequently receive a P6 for a cumulative tax code. For more guidance on tax codes, please see our Information Sheet on Starters and Leavers.