Tax can generally be paid in two ways – either taken from you before you get the rest of the money via Pay As You Earn (PAYE), or you pay it direct to HMRC via a Self Assessment Tax Return. Sometimes it is a combination of the two – you might have some tax taken from the money before you get it and then have to pay the difference (or claim a refund) depending on your own tax situation.
If the person paying your income to you deducts tax from your income before paying you the income due to you, it is often known as having tax ‘deducted at source’.
This means you only receive the ‘net’ amount of income after tax, rather than the ‘gross’ amount. When you are working out how much tax you are due to pay, you have to include the gross amount of your income, including any tax that has been deducted from the income before you received it.
In this section we look at different types of taxable income and the ways in which your tax is collected. We only deal with UK-source of income (Except for a very small part on foreign pensions).
HMRC ask employers to deduct tax from your wages or salary under the Pay As You Earn (‘PAYE’) system.
Under the PAYE system HMRC use a system of codes to tell employers how much tax to deduct. The aim is to collect the correct amount of tax each time you are paid and to spread your tax allowances evenly throughout the tax year. You do still need to check your own taxes, however, as the PAYE deduction will not always be right.
HMRC send a notice of coding (form P2) to you, which shows the allowances that HMRC think you are due and how HMRC are reducing your allowances to collect tax on other types of income that you may have.
Private and occupational pensions
HMRC ask pension payers to deduct tax from your pension income under the Pay As You Earn (‘PAYE’) system.
Under the PAYE system HMRC use a system of codes to tell your pension payer how much tax to deduct. The aim is to collect the correct amount of tax each time you are paid your pension and to spread your tax allowances throughout the tax year. You do still need to check your own taxes, however, as the PAYE deduction may not always be right.
HMRC send a notice of coding (form P2) to you, which shows the allowances that HMRC think you are due and how HMRC are reducing your allowances to collect tax on other types
You might have worked abroad and saved up in an overseas pension scheme or be receiving a foreign state pension. Note that in the UK, foreign pensions are usually taxed on only 90% of the sums paid to you. Do check that you are getting the reduction if you have a pension being paid from overseas – you make HMRC aware that you receive a foreign pension and will usually have to complete a self assessment tax return to claim the deduction.
The state pension
The state pension is taxable income, but you receive it gross. This means no tax is deducted at source from the state pension.
If your total taxable income, including your state pension, is greater than your allowances and reliefs, you will have to pay tax on the income that exceeds your allowances.
HMRC may collect any tax due on your state pension through the PAYE system, if you have a source of taxable earned income, such as a private pension or employment income.
If it is not possible for HMRC to collect any tax due on your state pension through the PAYE system, you may have to complete a self assessment tax return each year.
If you are self-employed, you must complete a self assessment tax return each year. This is because it is not possible for HMRC to collect any tax on your self-employment income through deduction at source.
You only pay income tax on any taxable profits you make, that is, the excess of your self-employment income when compared with deductible business expenses.
From 6 April 2016 banks and building societies will pay your interest gross (without tax being taken). Bank and building society interest is still classed as taxable income but the 0% savings rate and the personal savings allowance mean that most people don't have to worry about tax.
If your taxable income in total is less than your personal allowance or if your savings income is within your personal allowance (£11,000, 2016/17) plus £5,000, 2016/17 you will not need to pay tax. If your income is above £16,000, 2016/17 you are still covered by the personal savings allowance of £1,000, 2016/17 (£500 on incomes between £43,000 and £150,000, 2016/17). Any interest above these amounts is taxable and is your responsibility to inform HMRC and arrange for the tax to be paid.
Before April 2016 your bank or building society took off income tax at 20% before they paid you your interest.
If you have an Individual Savings Account (‘ISA’) with a bank or building society, you will receive your interest tax free and you need not include the amount in your income when working out your tax. Interest from ISAs is not taxable income.
Gift Aid alert – People who at present, use their savings income as part of their calculation to decide how much they can gift aid may be paying less tax and may need to recalculate. Failure to do so may mean they gift aid too much and may end up with a debt to HMRC.
Dividends are amounts paid by companies to shareholders of their shares and are a way of passing the profit of a company to its shareholders. Normally dividends are taxable income.
If you have an Individual Savings Account (‘ISA’) that pays dividends, you will not need to include the ISA dividends in your income when working out your tax. Dividends from ISAs are not taxable income.
The rules are changing in April 2016 when a dividend allowance of £5,000 is being introduced, the tax credit is being abolished. Any dividend payments above £5,000 will be taxable at either 0%, 7.5%, 32.5% or 38.1% depending on your total taxable income. For example, a person receiving £6,000 in dividends won't pay tax if their total taxable income is under their personal allowance. However, they will pay tax on £1,000 at 7.5% if their total taxable income is between £11,001 and £43,000, at 32.5% on an income between £43,001 and £150,000 and 38.1% on income of £150,001 and over.
Gift Aid alert – People who at present, use the now abolished dividend tax credit as part of their calculation to decide how much they can gift aid need to recalculate. Failure to do so may mean they gift aid too much and may end up with a debt to HMRC.
A purchased life annuity is an annuity purchased with any capital which is not compulsorily directed to the purchase of an annuity. So, a purchased life annuity is an annuity you buy with money you have saved up outside of pension schemes.
If you buy a life annuity the amount you receive is treated as savings income. As a result, the annuity payer will take off tax at the rate of 20% before it is paid to you.
Part of the annuity is treated like a return of your capital. Only the part that relates to income is taxed at 20% as savings income.
The final amount of tax due on your income from a purchased life annuity will depend on your situation. You may be able to claim a repayment of some or all of the tax deducted at source, you may have paid the correct amount of tax, or you may have to pay more tax and complete a self assessment tax return.
If you receive rental income from letting out a property, you must tell HMRC. The deadline for notifying HMRC about liability to tax on a new source of rental income is 5 October after the end of the tax year in which you first receive rental income. For example, if you start to receive rental income during the tax year 2015/16 (2016/17), you must notify HMRC by 5 October 2016 (5th October 2017).
If you have a source of income from which tax can be deducted under the PAYE system, for example, a salary or a pension, you may be able to pay any tax you owe on your rental property income through PAYE. Your tax code will be adjusted to reflect the amount of rental profit you make. You will not be able to do this if your taxable income that is not taxed at source, including your rental profits, comes to more than £2,500.
HMRC will ask you to complete a self assessment tax return each year but, you can still pay the tax due via the PAYE system if that is best route for you.
You only pay income tax on any taxable profits you make, that is, the excess of your rental property income when compared with deductible rental expenses.
Employees and pensioners have tax deducted under Pay As You Earn by means of what are called ‘PAYE codes’. You should check your code number and what tax is being taken off your income and query it with HMRC if you do not understand or think it might be wrong.
PAYE stands for Pay As You Earn. It is the system for collecting tax from your earnings or pensions during the tax year. The tax year begins on 6 April in the year and ends on 5 April in the following year.
PAYE is a three-party process, involving HM Revenue and Customs (HMRC), your employer or pension provider and you. Each has a role in its operation.
In most cases the tax due from you can be taken off your pay or pension under the Pay As You Earn (PAYE) system. How often tax is taken off depends on how often you are paid – usually weekly or monthly for employees and most pensioners, but some pensions might only be paid quarterly or annually.
Your employer or pension provider then uses that tax code to work out how much tax to take off your weekly or monthly pay or pension. They regularly pay over that tax (and National Insurance contributions, if appropriate) to HMRC.
Employers and Pension providers have procedures for running PAYE that allow them to use a tax code when paying you. It is important to check that your employer/pension provider has informed HMRC of your income. When new incomes start you should expect to see an updated coding notice from HMRC. If this doesn’t happen we suggest you contact HMRC and ask for one.
It is important to check that the tax codes HMRC have issued are being operated by your employer of pension provider. It can become more confusing in retirement as pensioners often have multiple sources of income including the taxable state pension that is paid gross. It is worth checking that the tax codes issued to you actually take the correct amount of tax. You can contact HMRC, Tax Help for Older People or if you have a 'personal tax account' you can view your tax codes there. To access your 'personal tax account' go to www.gov.uk/personal- tax-account and follow the prompts. You will first need to follow the verify process to prove your identity.
If you are employed you will be given a payslip each time you are paid. It may show the tax code your employer used to work out the tax to deduct from your gross pay.
If you are getting a pension, you generally do not get a payslip with each pension payment. However, you should get some form of notification if there is any change to the pension payment if, for instance, your tax code changes.
If you are unsure what code is being operated by your employer/pension provider call and ask.
So long as you are employed or receiving a pension at 5 April, the end of the tax year and pay tax, your employer or pension provider will give you an ‘end of year certificate’ (form P60 or its equivalent) by 31 May. This will show your pay or pension and the tax deducted and usually the final tax code operated. Your employer or pension provider will give the same information to HMRC.
Although the system sounds pretty simple, things can go wrong so it is very important that you check:
This guide aims to help you to do just that. However if you are concerned always contact HMRC.
Most people who pay tax in the UK are entitled to personal allowances. These are the starting point for most tax codes. If you have no other income, you can have earnings or pensions up to the amount of your personal allowance without owing any tax.
There may be other amounts to add to your personal allowances to increase the amount you can earn before paying tax (your 'tax free amount') and therefore reduce the tax you have to pay. For example, there may be an amount to be added for certain job expenses (such as using your own car for business), perhaps blind person's allowance, marriage allowance, flat rate expenses for say, uniform cleaning or professional subscriptions.
There may be some items in your tax code that reduce your tax free amount. For example:
Your tax free amount, reduced as necessary, is turned into a tax code.
HMRC divide the tax free amount by ten and then add on a letter. For example, in 2016/17, someone aged 69 whose tax free amount is just the personal allowance of £11,000 will have a tax code of 1,100L.
See ‘K codes’ below to find out what happens when the reductions to your tax free amount are more than your personal allowances.
The letters used in tax codes often will not mean much to you. Most are there for HMRC or your employer or pension provider to refer to.
Personal allowances and tax rates may change. Rather than issue new tax codes to millions of people, HMRC will tell employers and pension providers to simply increase by a certain amount all codes ending in, for example, the letter L.
These are the letters used in tax codes:
Items that reduce your tax free allowances can add up to more than those allowances, resulting in minus allowances. When this happens, these minus allowances are treated as extra income on which tax is due and a special code number, beginning with the letter K, is used.
If you divide the minus allowances by ten, then take off one, you will get the K tax code. For example, if you have minus allowances of £2,970, your tax code will be K296.
Although K codes are designed to collect extra tax, if you have a K code, your tax deduction for each pay period cannot be more than half of that pay or pension. For instance, if your pay for the week is £300, a K code cannot result in more than £150 being deducted from you in that week.
Code BR stands for basic rate (in 2016/17, 20%) and is usually used for a second employment or pension where there is no tax free amount available to reduce your tax deductions. It is different from code 0T. With code BR, tax will only be deducted at basic rate at this job or pension, no matter how much you are paid. But where code 0T is used, tax at the higher and additional rates can be deducted once your income goes over a certain amount.
This code is used if all income from this employment or pension is expected to be taxable at 40% (the higher rate). There will usually be another employment or pension where your tax free allowances are given and where at least some of your tax will be deducted at 40%.
Emergency tax codes
When you start a new employment or pension your employer /pension provider will follow the PAYE procedures to issue you a tax code which will be operated until HMRC issue the correct code.
This is a complicated process and one that continually fails. It is important that you check that the proper tax code has been issued by HMRC and is operated. Never assume that the initial code is correct.
Although millions of people pay their tax under the PAYE system, not everyone needs a tax code notification each year.
If, for example, your tax free amount is just the basic personal allowance then you may only have received one PAYE coding notice – when you first started work. This is because if the amount of the basic personal allowance changes each year, HMRC and your employer can update your tax code automatically by reference to the code letter ‘L’, without HMRC needing to contact you.
Tax can become more difficult in retirement and most pensioners have several sources of income. They also receive the taxable state pension which isn't taxed at source. Pensioners’ personal allowances may change as their income changes so they do tend to get PAYE coding notices each year - usually in February for the tax year starting on the next 6 April. If you do not receive one contact HMRC on 0300 200 3300to ask for a copy.
People whose tax codes are reduced to take account of:
are sent a PAYE coding notice each year. These notices are usually sent in January for the tax year starting on the next 6 April.
Employees and pensioners who have to complete tax returns will also be sent annual PAYE coding notices.
Your circumstances can change during the tax year so your tax code can be amended at any time and a new PAYE coding notice sent to you. Keep all your coding notices to check that HMRC have calculated your tax code correctly and that your employer or pension provider is using the correct tax code for you.
HMRC re designed the coding notice in 2015 and they now include all of your sources of income on one document. This much easier to read but you still need to check that the information is correct.
PAYE codes are generally notified to employees by a paper 'coding notice' sent through the post. But if you fill in a tax return each year and are registered for Self Assessment Online, you can also view your PAYE Coding Notices online. Before you can use this service, you must have registered for HMRC Online Services and enrolled for Self Assessment Online.
Each PAYE coding notice can be split into roughly four sections for checking:
This first section will contain: your title (Mr, Mrs, Dr, Sir etc), your name and address, your national insurance number, the date of issue of the notice and the tax year to which it relates.
In the next section called 'This is how we worked out your tax code' HMRC will first set out your personal allowances and anything else that increases your tax free amount, such as job expenses or the marriage, married couple's and blind person's allowance. These items are then added up giving the 'total' allowances.
Then, anything that reduces your tax free amount, such as the state pension, a reduction to collect unpaid tax or an estimate of untaxed interest or an underpayment for a previous year is then taken off leaving your 'total tax free amount'.
This 'total tax free amount' is then set against your income sources until it is used up. The tax code is then shown to the right hand side of the notice, calculated as below;
This leaves you with a 'total tax free amount' which, if positive, is divided by ten and a letter is added at the end to give you your tax code. For example, a tax free amount of £4,921 becomes tax code 492L.
If the result is negative (you have a minus tax free amount) it is divided by ten, a figure of one is taken away and a K is put before the result to give you your tax code. For example, a minus tax free amount of £2,970 becomes tax code K296.
Once the 'total tax free amount' is used up subsequent sources of income will be taxed at BR (basic rate taxpayers)
If you think anything in your tax code is wrong, contact HMRC as soon as possible on 0300 200 3300. Do not expect your employer or pension provider to do this for you, they only act on HMRC instructions.
A note will be provided for every item in the tax code calculation. These notes are intended to help you to check your tax code but the way the tax rules work means this is not always straightforward.
If you were born before 6 April 1938 and your income is more than £27,700, 2015/16, Gift Aid payments reduce your total income for the purposes of calculating your age-related personal allowance, meaning you pay less tax. This means that an 'estimated income' figure on your coding notice should have been calculated deducting Gift Aid payments.
There is a snag. As Gift Aid payments are treated as paid after basic rate tax (20% for 2015/16), they need to be what is called ‘grossed up’ before they are deducted. So you take the amount you paid, multiply it by 100 and divide it by 80 – meaning for every £80 you pay in Gift Aid, you get a £100 deduction from your income in the age-related personal allowance calculation.
This section does not apply from 6 April 2016.
If you have a ‘reduction to collect unpaid tax’ item in your code number, your coding notice will show the actual amount of unpaid tax. HMRC ’gross up’ that figure (multiplying by 100 and dividing by 20, if you pay tax at basic rate) and reduce your tax free amount by the result, so you pay extra tax on the grossed up figure.
For example, if you are aged 54 and owed £47 for the 2016/17 tax year, the calculation box on the 2016/17 PAYE coding notice would look like this:
This is how we worked out your tax code(s)
|Your personal allowance (after increases)||£11,000||Go to note 1|
|Reduction to collect unpaid tax (£47)||£235||Go to note 3|
|Total tax free amount||£10,765|
The extra tax that you will pay at 20% because of having £235 fewer personal allowances will collect the £47 unpaid tax (235 x 20% = 47).
If you have married couple’s allowance in your coding an adjustment has to be made because your tax free amount reduces the tax you pay at 20%, whereas the law says that tax relief for married couple’s allowance is to be given at 10%.
For example, if you are a married man, born before 6 April 1935, and your income in 2016/17 is £19,880, your tax relief for married couple’s allowance will be £8,355 at 10% = £835.50.
But the calculation box in your coding notice would look like this
This is how we worked out your tax code(s)
|Your personal allowance||£11,000||Go to note 1|
|Married couple’s allowance (add)||£4,178||Go to note 3|
|Less state pension||£7,865||Go to note 3|
|Total tax free amount||£7,313|
Having £4,178 in your coding reduces the tax you pay, at 20%, by £835.50. This is the same result as £835.5 at 10%.
If you are in receipt of the marriage allowance from your spouse your personal allowance will be increased by £1,100, 2016/17. Their personal allowance will be reduced by the same amount.
The calculation box in your coding notice would look like this
This is how we worked out your tax code(s)
|Your personal allowance||£11,000||Go to note 1|
|Marriage allowance (add)||£1,100||Go to note 3|
|Less state pension||£7,865||Go to note 3|
|Total tax free amount||£4,235|
The final note on the coding notice tells you: