A recent question from an employee of a client prompted this article – they were quite surprised that in April of the new 2017/18 tax year that they had been taxed on their earnings, despite the fact that they had not yet earned the £11,500 that they thought they should earn tax-free! This may seem like a surprising misunderstanding of the UK PAYE tax system, but you might be surprised how often it comes up. So we thought we would explain it.
Cumulative tax basis
The tax-free allowance as set by HMRC is an annual allowance, but it is applied to payroll on a monthly or weekly cumulative basis.
This can create a great deal of confusion, as even an employee carrying out their very first pay period for the tax year may have tax deducted from their earnings. Despite the fact their earnings are below their annual allowance, so why is it they are paying tax?
Payroll is not run annually, it is instead run on a cycle set by the employer, such as weekly or monthly. Therefore any tax-free allowance is shared evenly across the pay cycle.
The tax calculated on week 1 or month 1 of the pay cycle is based on what the employee should have paid after deducting 1/52 or 1/12 of the annual tax allowance.
The tax calculated on week 13 or month 3 of the pay cycle is based on what the employee should have paid after deducting 13/52 or 3/12 of the annual tax allowance.
A weekly pay cycle would give you 1/52 of your allowance each week, whereas a monthly pay cycle would give you 1/12 of your allowance each month. You will receive an extra month or week of tax-free pay each pay period, and your tax will be calculated on how much you have earned in the year to date, and how much tax you have paid in the year to date.
This is referred to as cumulative tax basis and means that you should always be paying tax on a payroll year to date basis.
Let’s look at an example:
1. My Tax Code is 1150L – This means my annual tax-free allowance is £11,500 (1150 x 10)
2. My employer pays me weekly – This means my weekly tax-free allowance is £221.15 (£11,500 / 52)
3. How the tax is calculated – The first £221.15 I earn is entirely tax-free, charged at a rate of 0%. Any amount earned above the £221.15 is taxable.
4. Say I earn £300.00 – I only pay 20% PAYE tax on the difference between my earnings and my tax-free allowance for the week (£300.00 – £221.15 = £78.85), which would generate £15.77 (£78.85 * 0.20) PAYE tax.
The key item to remember is that you don’t pay tax on all of the £300.00, just any amounts over and above the allowance.
Why is it done this way? If the allowance was not spread over the year, there would be a considerably high risk of an employee underpaying on tax – especially if they have more than one employer throughout the tax year. This is HMRC’s way of preventing underpayments of taxes.
National Insurance works in much the same way – however, these thresholds for earnings may vary each year and will be available on HMRC online.
You may be earning less than your tax-free allowance but may still be charged National Insurance, as the thresholds are considerably lower.
Week 1/Month 1 basis
Occasionally, HMRC will update your tax code to a week 1/month 1 basis which means that any previous pay you have received and any tax you have paid in the year to date are not taken into consideration when your pay is calculated.
Week 1/month 1 basis is often used when there is an underpayment of tax in an earlier year, if you have multiple jobs or if HMRC is reviewing your tax account. Week 1/month 1 basis will ensure you are only taxed on the pay that you have earned in that week or month. At the end of the year HMRC will review your tax account to assess if you have paid too much or too little tax and then send you a statement requesting payment or a refund of your overpayment.
What to do if you think your tax code is wrong
You can call HMRC and update them with your current circumstances. If they agree that your tax code is wrong, they will update their records and send new tax code notices out to your employer.
You can call HMRC on the Self Assessment Helpline on 0300 200 3310 – you will need your national insurance number to hand.
Your Online Tax Account
If you have not done so already – you should set up your personal tax account with HMRC. Use your personal tax account to check your records and manage your details with HMRC.
You can find more information on how to do that here: Personal Tax Account
What happens if I have overpaid my tax?
HMRC do run their own checks and balances at the year-end so if they find that you have overpaid – they will often issue a refund without you having to ask for it. However – they may not be as quick as refunding any overpaid tax as you might like!
If you have overpaid your tax during the year – you can also ask for a refund through your online tax account – this might be a little faster than waiting for HMRC to action your refund.
You can also call HMRC to check your account balance and the status of any overpayment on the Self Assessment Helpline on 0300 200 3310 – you will need your national insurance number to hand.