We get asked a lot about tax codes and how tax works in the UK. Here we’re going to tackle this topic and explain it with some quick examples.
Tax in the UK can be a bit tricky to understand and there are lots of confusing headlines and stories out there to bamboozle you. This is a basic guide to tax in the UK, and we are going to discuss personal tax from earnings.
Let’s start with the basics.
HMRC
HMRC – stands for Her Majesty’s Revenue & Customs - is the department of the government responsible for collecting taxes. This is what people mean when they talk about ‘the taxman’.
These are some of the types of tax HMRC covers:
VAT
Income tax National Insurance
Corporation tax Capital gains tax
Motoring taxes Inheritance tax
Stamp duty Insurance Premium Tax
Air Passenger Duty PAYE
And so forth
It's a really long list!
In this article, we are only going to look at PAYE.
PAYE – or Pay as You Earn – is a type of income tax. It is the amount that is automatically deducted from your salary on your payslip each month before you even get a sniff of it. HMRC gives you a special tax code and your tax code determines how you will pay tax and your employer uses your tax code to deduct the correct amount from your salary each month and give it to HMRC.
PAYE is applied to your normal salary, sick pay, maternity pay, directors’ fees, and pensions.
TAX CODES
A tax code is usually in the form of a number followed by a letter and it is a calculation of how much tax you need to pay in the tax year. You can find your tax code on your payslip or P60 and on the letter they write to you at the start of each tax year.
BASIC RATE
The tax-free allowance for everyone is currently £12,500.
This means you can earn £12,500 before you start to pay tax. Once you earn over £12,500, you are taxed at the basic rate. This is currently 20%.
So if you earn £21,500 per year, you pay tax on £9000 at a rate of 20%. This means you pay £1800 tax per year or £150 per month. Your employer deducts this automatically from your payslip – hence the term ‘pay as you earn’.
If you earn £31,500 per year, you pay tax on £19000 at a rate of 20%. This means you pay £3800 tax per year or £317 per month.
HIGHER RATE
Higher rate tax is paid on income above £50,000.
So if you earn £60,000, you will pay zero tax on the first £12,500 as above, 20% tax on your income between £12,500 and £50,000.
This is £37,500 at 20% which equals £7500. And you'll pay a 40% tax on your income above £50,000. This is £10,000 in this example which equates to another £4000 in tax. This brings your total tax bill to £11500 or £959 per month.
Some people get this mixed up and think that as soon as you enter the 40% tax bracket, all your income is taxed at 40%. This is not how it works.
The higher rate (40%) tax bracket applies all the way up to £150,000. Above this point, you will pay an additional rate (45%) on your income.
Also, if you earn above £100,000, your tax-free allowance reduces by £1 for every £2 earned proportionately to zero. If you have any questions about this, feel free to contact us, but we will assume that most people reading this article aren’t worried about this problem.
TAX CALCULATION
To calculate your tax just remember this: If you earn more than £50,000; the proportion above this amount times 40% and the remaining amount between the two thresholds, - which is £37,500 - times 20%.
Remember, the figures used in this example are based on the tax year 20-21 and will likely change from year to year.
The basic concept remains the same though. Further information is available from the HMRC website.
Wondering how to simplify your tax calculation process and put it on autopilot? Let’s our payroll software do it for.