If you are a citizen of the UK, you must know about tax codes. The tax you will pay is determined by the tax code that applies to you. Tax codes are there to ensure that you pay your share of tax liability fairly to the government. Apparently tax codes can seem very confusing and following the rules and applying them can be an overwhelming affair.

But with the right guidance you can rest assured that you are applying the right tax code, and managing your tax liabilities accurately. In this blog, we will discuss all the necessary details about the tax code of the UK taxation system. Understanding the tax code system will not only help you be tax compliant but also manage your finances well and pay the right amount of tax.

What is a Tax Code?

To put it in simple words, the UK tax code is a combination of numbers and letters that the HMRC (His Majesty’s Revenue Customs) uses to determine an individual’s tax liability i.e., the amount of tax that an individual has to pay the UK government. These tax codes are like a personalised indicator that shows different categories of taxpayers, like the tax allowances an individual is eligible for tax, deductions they can avail of, and any other additional income sources that should be taken into consideration. It also shows the amount of free tax income that an individual is eligible for.

Once the tax code of an individual is determined basis their income, allowances, deductions and additional income, employers use these tax codes to deduct the tax from the wages, and salaries of their employees before it is paid out. In the UK, the tax is generally collected at the source. By attaching tax codes to individuals, the UK government maintains a clear and distinct record of the taxpayers and an accurate assessment of the corresponding tax liability.

Employers and pension providers in the UK use PAYE (Pay As You Earn) tax codes to determine how much income tax should be withheld from an employee's or pensioner's pay or pension. HMRC issues the tax code, which is typically made up of both numbers and letters. It serves as a proxy for a person's taxable income (also known as personal allowance) for the tax year and aids in calculating how much tax will be deducted from their paychecks.

Understanding the Structure of the Tax Code

The structure of the tax code in the UK is a number obtained by dividing an individual tax-free personal allowance of the individual by 10. For instance, a personal allowance of £12,570, would have the tax code number 1257. Additionally, there is a letter that shows unique situations or adjustments that affect an individual's tax code.

The standard PAYE tax code letters are –

  • L: Indicates that you are eligible for a standard tax-free allowance.
  • M: This letter shows that part of your partner's allowance was transferred to you.
  • N: Indicates that you transferred 10% of your allowance to your partner.
  • T: Review needed from your employer.
  • 0T: Personal allowance used up or new job details missing.
  • BR: Basic tax rate applied to all income.
  • D0: Higher tax rate on all the income earned (multiple jobs).
  • D1: Additional tax rate on all income earned (multiple jobs).
  • NT: No tax on this income.

There are two emergency payee tax codes as well –

  • 1257L W1 (weekly basis)
  • 1257L M1 (monthly basis)

In cases where HMRC lacks sufficient information about a person's income, an emergency PAYE tax code is a temporary tax code that is assigned. In the absence of a valid tax code, employers or pension providers utilise the emergency tax code to determine how much income tax should be deducted from a worker's pay or pension.

An individual may overpay or underpay taxes while on an emergency tax code. The right tax code will be issued by HMRC and sent to the employer or pension provider after it has all the necessary data regarding the person's income and tax situation.

Normally, HMRC will make a modification to a person's tax code or make a direct payment to them where they have overpaid tax while using an emergency tax code. If they have underpaid taxes, HMRC collects the difference by changing the person's tax code for the rest of the tax year.

There is another tax code that individuals should be aware of. It is called X tax. The "X" tax code indicates that a person is not liable for income tax deductions from their pay or pension. This tax code is somewhat uncommon and is typically used in specific situations, such as when a person has reached the state pension age and has used up all of their personal tax exemptions from other sources of income, such as a private pension or investments, and has reached the state pension age.

Understand the Basic Tax Code

The basic rate or BR tax code denotes a 20% tax rate on all of your income derived from this source. Until your company has all the information needed to provide you with a suitable tax code and apply the proper income tax deductions, the code is typically utilised temporarily. It is important to examine the BR tax code to make sure you aren't paying more income tax than necessary even though it may not be incorrect.

Each tax year, all taxpayers are given a personal allowance that is tax-free. In other words, you only begin paying taxes after your income exceeds your personal allowance. Now all of your salary is subject to 20% taxation if you have been assigned a tax code BR; the tax-free personal allowance is not taken into account.

Note that if you have been wrongly issued tax code BR,  it is crucial to get your tax code rectified as soon as possible. Without receiving the advantage of your tax-free allowance, you run the risk of paying too much income tax. Any excess taxes paid for that tax year are often reimbursed through your salary when your code is changed. You can also be due a refund if you had a BR tax code in the prior year or any of the previous four tax years.

Change in Tax Codes

Tax code might change for a number of reasons, frequently as a result of changes in your personal situation, the beginning of a new work, or the receipt of increased taxable income or benefits. Here is a list of circumstances that may require a change of tax codes -

  • Changes in personal circumstances: If your personal circumstances change, such as if you get married, get divorced, or become widowed, or if your eligibility for tax advantages or credits changes, your tax code may also change. These modifications may have an impact on your personal allowance and tax code.
  • Joined a new job: Your tax code might change when you start a new job. Typically, your company will give you a P45 from your prior position that includes your tax code information. Your employer may utilise a starter checklist if you don't have a P45 to acquire the relevant information, or you may be temporarily assigned an emergency tax code until HMRC supplies the proper tax code.
  • Additional sources of income: Your tax code may change to take into account the increased income and make sure you are paying the appropriate amount of tax if you start earning money from additional sources, such as rental income, investments, or second employment.
  • Alteration in benefits received: If you begin or stop getting benefits from your workplace, such as a company car or private health insurance, your tax code may need to be changed. These advantages are regarded as a component of your income and may have an impact on your personal exemption from taxes.
  • Alteration in your tax-free allowance: Adjustments for inflation or modifications to tax law may result in changes to your personal allowance. Your tax code may change as a result to reflect the revised allowance.
  • Overpayment or underpayment of tax: HMRC may modify your tax code if you overpaid or underpaid tax in a prior tax year in order to collect the overpayment or issue a refund for the underpayment. This could also happen if your tax code contains mistakes or if your situation changes during the tax year.
  • Reaching the age for state pension: When you reach State Pension age, you stop making National Insurance contributions; this shift may have an impact on how your taxes are calculated, especially if you continue to make money while collecting your State Pension or have other sources of income.

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In conclusion, it is extremely important to be well aware of the meaning and implications of various tax codes of the UK taxation system. In addition to this, it is equally important to know the circumstances that can change your tax code. Being aware of this nitty-gritty will help you be tax-compliant. However, understanding the intricacies of the tax code can become difficult. So partner with us today. Not only we will help you with applicable tax codes and their due processes but also help in case of any change or alteration surrounding your tax code.