How to understand Tax codes?

INTRODUCTION

6th April 2016 was the beginning of the tax year with the new tax code 1100L (tax code for tax year 2015-16 was 1060L). This change in the tax code meant that the take-home pay was revised and gave additional benefit to the employees. For tax year 2016-17, the tax code 1100L communicates to an employer that an employee is entitled to earn £11,000 an annual before being taxed.

HM Revenue and Customs (HMRC) issues tax codes every year to communicate the tax-free allowance a person in the UK is entitled for. A tax code is a 4-digit number followed by an alphabet. This reflects an individual’s Personal Allowance for the pertinent tax year, divided by 10, and a letter giving the employer details about the personal tax circumstances. This information is imperative as it is used to compute the correct amount of tax to be paid. If the tax code ends with the letter ‘Y’ it means that an individual was born before 6 April 1938 and is eligible for the entire Personal Allowance. Furthermore, if the tax code ends with ‘M’ or ‘N’ it means that an individual has either transferred or received 10% of the Personal Allowance to/from their partner.

Tax code 1100L – Tax free personal allowance for 2016-17

Everyone in the UK is entitled to a tax-free personal allowance which means that if an individual receives income from a job or pension, the initial £11,000 he / she receives will be tax free. It is imperative to identify with the fact that tax free allowance is more often than not split evenly over the year. The tax system is intended this way to ensure that an individual pays a steady amount of tax each pay period.

Working out the Tax code

A tax code is usually based on an individual’s circumstances and may not always be 1100L. If an individual is not on a standard tax code, HMRC will send the individual a pay-as-you-earn (PAYE) coding notice before the tax year ends to explain how they computed the new tax code. Common reason why a tax code may be different from 1100L:

• An individual has more than one job
• An individual has an underpayment from a preceding year
• An individual receives company benefits (medical insurance or company car) from the employer

For a second job, the typical code is BR – Basic Rate (20% deduction). However, there might be some circumstances when these codes will not result in the correct deduction. Let's understand these with a few examples.

Example 1: If an individual earns less than £11,000 in their main job (tax year 2016-17) and have more than one job

Solution: Assume income from the first job is £8,000, and from the second job is £4,000. Overall, an individual earns £12,000 and should pay tax on this amount. But, standard code (1100L) for the main job and BR for the second job would mean that an individual pays too much tax during a tax year. This is because an individual is earning less than £11,000 (tax-free personal allowance) and £3,000 (£11,000 – £8,000) of the tax free pay is unused. An individual can either ask for a refund from HMRC at the end of the tax year or decide to split the tax-free pay between jobs.

Example 2: John has untaxed income as well as a main job
Solution: John as an employee is earning £14,000 an annual and also has rental income of £8,000 a year, less expenses of £5,000 – a rental profit of £3,000. John can avoid being in self-assessment by asking HMRC to alter his tax code for the tax due on his rental income. Doing so, will mean that the tax code number would be different than the standard 1100L (800L as £3,000 is used to cover the rental income)

To work out a tax code, an individual must add up all the tax allowances and then add up the income on which tax has not been paid. This may comprise of untaxed company benefits, untaxed savings interest, or income from another job. Deductions are subtracted from the allowances and the remaining amount is the income for a tax year. For example:

1. Allowances = Basic personal allowance of £11,000
2. Deductions = NIL
3. Personal allowance for 2016-17 = £11,000 divided by 10 i.e. 1,060
4. If an individual was born after 5 April 1938; also qualifies for full Personal Allowance = letter L
5. Therefore, Tax code = 1100L

Tax code letters and their meaning

Letters in the tax code refer to an individual’s situation and provide details on how it can affect the Personal Allowance

If a tax code has letter 'K' as a prefix

A tax code with letter 'K' at the commencement mean an individual's income has not been taxed in any different way and it's worth more than the tax-free allowance. This usually happens if any individual:

• Is paying tax from a previous year through their wages or pension
• Is getting state benefits (state pensions) on which tax is payable
• Is getting benefits (like a company car or health insurance) from work that an individual must pay tax on

Tax code ending with 'W1' or 'M1'

W1 (referring to week 1) and M1 (referring to month 1) are emergency tax codes. This means the payable tax is based only on what an individual is paid in the current pay period, and not the whole year. Codes ending with W1 or M1 are known as ‘non-cumulative’ and appear as '587L W1' or '587L M1'. Emergency tax codes are generally updated automatically after an individual provides new employer with P45. A new tax year always begins with a normal tax code, not an emergency one.

1100L as 'emergency' tax code

When an individual takes on a new employee, the tax code is normally worked out using their P45. The code will usually be made up of several numbers and a letter, such as 1100L. 1100L is an emergency tax code only if ends with 'W1', 'M1' or 'X'. Emergency codes are used if a new employee does not have a P45.

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About the author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.