This week, HM Revenue and Customs announced that their annual reckoning of tax collected under PAYE will soon be calculated, and unsuspecting taxpayers will get a nice, or nasty surprise in the mail.
Although the new system is no, supposedly, working properly, HMRC expects that any repayment cheques for the overtaxed will be sent out in August and September. Calculations for those who owe money will be sent in batches after that, with the last going out in December and up to £3,000 per individual will be collected this time via PAYE , more than the previous limit of £2,000. The money will be taken from their earnings each month via a change to their PAYE tax code for 2012/13.
Of course, PAYE was introduced to make income tax payment and collection easier for the huge percentage of employed taxpayers in the UK. Assuming your PAYE notice of coding works properly, you should never face a large tax bill, or a large tax repayment, at the end of any tax year.
However, PAYE codes are a blinking mystery to most people (and many accountants), but if you don’t know if your code is right or wrong, how can you advise HMRC when it needs changing to avoid that potential hefty bill. And do you trust them to get it right at the end of the day? Seriously?
How do I decipher my tax code?
PAYE codes are normally comprised of three numbers either preceded by or succeeded by a letter and adding a '5' to the end of the three numbers will give you the tax-free allowance applied to your earnings, for example, if your notice of coding reads 747L, your tax-free allowance is £7,475; if 240T, then your allowance is £2,405. Simples.
The letter used does not really matter for the purposes of deciphering your tax code unless that letter is a K. Many people with company cars will have a K code, which basically means your benefits are more than your personal allowances, so these codes add notional extra income to your salary to make sure you pay more tax on a monthly or weekly basis than your salary alone would suggest.
The standard, non-adjusted tax code for 2011/12 is 747L, which equals the normal personal allowance of £7,475 per annum. If your tax code is 747L, you are just getting the benefit of a full allowance, with no deductions for things like company benefits in kind or untaxed income. If your tax affairs are simple, you can probably breathe a sigh of relief and go off and do something else.
However, if your tax code is different, or you do have benefits that ought to be included in your tax code, you need to understand the numbers behind it. When HMRC send you the notification of your tax code, you should receive a document with some numbers on. On one side of the page are your allowances and the other side is for deductions. The easiest way to imagine the system is as a set of scales.
On the allowances side, most people will start with 7,475. To this side will be added any extra allowances due, such as additional age related allowances for those over 65/75 or blind person's allowance. If you earn, or are expected to earn over £100,000, you will either get no allowance or a reduced allowance on this side.
So far so good. Other things that might appear on this side are specific items that you may deduct from your income on your personal tax return. A good example of this would be a professional subscription that you pay yourself (rather than claiming as an expense from your employer).
Now for the other side. The most common deductions seen are for benefits in kind. If you have received a benefit for one tax year, it is assumed you will receive the same benefits in future years, so things like company car benefits or private medical insurance will be included here to weigh down your deductions side, thereby reducing your allowances.
Other things that are often seen are small sources of untaxed income. Things like a state pension or gross bank interest or rental income, provided they are small when considering the employment income, can be added here, meaning you effectively pay the tax liability arising on these untaxed sources monthly through your pay packet instead of in a lump sum at the end of the year.
The final thing that will often appear here are adjustments. Certain adjustments are obvious- if you have chosen (or been made) to carry forward a previous tax bill to pay by PAYE, this will show here; similarly HMRC could include estimated underpayments if they have become aware of a change in circumstances part way through a year. This is basically them guessing how much tax they think you will owe at the end of a year and adjusting accordingly. Note that a £100 underpayment will not be collected by a £100 deduction in your notice of coding. If your marginal rate of tax is 40%, the restriction in your coding will need to be £250 (100/40%) in order to increase the tax collected by £100.
Other adjustments may be more complicated. Certain age allowances, for example, are phased out once income exceeds certain levels.
The final number
Once all allowances and deductions are included, the net answer is your tax code. If the number is positive, a ‘normal’ tax code will arise. If negative (i.e. deductions exceed allowances), the last number is reduced by one and a K code ensures the extra tax due will be collected.
So how do you check your code? Well, you need to make sure all the elements included are correct and reasonable. If your code shows subscriptions that you no longer pay, or underestimates the value of your car benefit, you will likely have to pay a lump sum at the end of the year. Similarly, deductions that should no longer be there, like company cars, or incorrect estimates of underpayments could mean that you are due a repayment of tax.
If you check your code, you can avoid problems arising in the first place, but also know whether to expect a reconciliation letter from HMRC. Admittedly, prior knowledge of an underpayment letter might not help you out, but if you calculate you have overpaid tax and you don’t get a letter, at least you will now be able to chase it up.