You are allowed to earn a certain amount before you start paying tax. This is the personal allowance which, for 2012/2013 is £8,105, and for many employees this is the only item which appears in their tax code (PAYE code). The code is denoted without the last digit so many employees have a code of 810L which will allow, over a whole year, earnings of 8105 before tax is deducted. The “L” has no tax affect and will be disregarded in this discussion.
In most cases, the effect of using the code in a payroll calculation is to utilise 1/12th of the figure (our £8,105) each month (or 1/52nd every week) on a cumulative basis. So, taking monthly pay as an example, in the first month there will be no tax deducted if earnings are under £675 (1/12th of £8,105). By the second month, the earnings could total £1,350 (2 lots of £675) and there would be no tax. The PAYE system does the calculations by looking at the year so far and not by looking at each month individually.
As an example, take earnings of £675 in each of the first two months (total £1,350) – clearly there would be no tax deducted in either month. Contrast that with a situation where the earnings were £1,000 in the first month and then £350 in the second month – one imagines there should be no tax and indeed that is the case. Although in the first month there will have been some tax deducted as the earnings exceeded the limit (tax is applied only to the £325 excess earnings), by the time the calculation is done for the second month the system realises that on a “so far this year” basis the tax should be zero so any tax deducted in the first month is refunded in the second month.
Sometimes it is necessary for the calculation to look only at this month and not on the “so far this year basis” but those are special circumstances. Such codes are called “Week 1” or “Month 1” and are usually found where the code has been reduced – a reduced code means reduced allowances which in turn means higher tax. Let’s see why these work differently:
If a code is reduced part way through the year it will mean that the code was too
big in the earlier part and too little tax was therefore deducted – so the system
would now correct that by collecting the “back tax” all in the current month. However,
it is possible that this might make the take home pay too small to meet normal living
needs and commitments so, to prevent this, such codes deal only with the current
month (and likewise for future months) without collecting any “back tax”. Any tax
owed for the earlier months will, instead, be collected later -
That’s a brief look at the way tax is calculated by reference to the tax code and leads us on to a look at some other things you might find in your tax code:
If you have taxable benefits from your employer then the tax on those benefits must be collected somehow. Making the tax deduction higher is achieved by reducing the code. With benefits of say £1500 the code might look like this:
Personal allowance 8,105
Benefits -
Net allowances 6,605
(Code is 660L)
If you receive a state pension then tax needs to be collected on that (the pension itself is always paid without any tax deducted). This is achieved by reducing the code just as with the benefits in the example above.
On the other hand if there are additional allowances (perhaps in connection with pension contributions) then an appropriate amount would be shown to increase the code.
Using all of those elements a code might look like this:
Personal allowance 8,105
Pension relief 2,100
Benefits -
State pension -
Net allowances 4,705
(Code is 470L)
It is worth pointing out that where there are elements in your code other than the personal allowance, those extra elements are usually estimated because they are for the current year and aren’t yet known. Nonetheless they need to be included to try to get your tax deductions as close as possible to what they should be. Any error in the estimates will result in either an underpayment or overpayment of tax. How the underpayment or overpayment is dealt with will depend on your overall tax circumstances.
A final word on some special codes: Ignoring a couple of less common situations, two other types of code are often encountered:
BR will deduct a flat 20% tax without any allowances. This would commonly be used for a second job (assuming your allowances have been used up on the first job).
D0 (or D1) will deduct tax at a flat 40% (or 50%) and would again be used where the allowances have already been used elsewhere but in this case where there is a need to deduct the higher rates of tax (perhaps you are quite a high earner).
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Your tax code explained
