Tax codes are used to work out how much tax an employee should pay over the course of a tax year. This guide gives an insight into how tax codes are applied to payroll and how it is worked out.
The number in a tax code if it ends with a L, M, N, or T relates to the amount of personal tax-free allowance an employee is entitled to throughout the tax year.
There is usually some confusion around this as it is assumed that it means an employee will only pay tax after the have reached a tax free allowance but tax codes are normally cumulative and so the tax free allowance is spread throughout the year.
Different rates around the UK
There are different tax rates for England, Wales, Scotland and Northern Ireland and how much you pay will be dependent on where you live and how much you earn. A standard tax code in England is 1257L, Scotland will be S1257L and Wales will be C1257L.
When an employee has tax code 1257L (most common tax code for people who have one job or pension) it means the employee can earn £12570 per year tax free. To make sure that employees pay any tax over this allowance throughout the year, each pay period has a tax free amount. This is so that employees pay tax evenly throughout the year and helps avoid unpleasant tax surprises at the end.
How does a standard 1257L tax code work?
Depending on how often the employee is paid determines how the tax free allowance is broken down.
For weekly pay - the tax free allowance of £12570 is divided by 52. Each week, any earnings above £242 will be taxed.
For monthly pay - the tax free allowance is divided by 12. Each month, any earnings above £1,048 will be taxed.
However, there will be a little adjustment throughout the year as £242 x 52 does not add up to £12570. This is where software comes in and makes sure that the correct amount of tax is paid without having to be manually adjusted.
What does this mean over the tax year?
If the tax code is cumulative, then each payment the employee receives, is added together and compared to how much much tax free allowance they should receive.
Let's look at a simple calculation based on an employee that lives in England.
Example - Monthly Paid Employee with a 1257L tax code.
The employee starts a new job in April and hasn't worked anywhere else since the 6th April. They are paid on the last working day every month.
Month 1 - because the employee starts mid month, they are only paid £500. This is below the tax free allowance of £1048 and so no tax is paid.
Month 2 - employee is paid £2000. Because the tax code is cumulative, the £500 and £2000 are added together meaning they have earned £2500.
For Month 1 and Month 2, they have a total of £2096 tax free allowance. £1048 for each month.
£2500 is more than the tax free allowance and so they will pay some tax on £404.
What happens if the tax code has a W1, M1 or X?
If the employee had a W1, M1 or X after their tax code or it is shown on their P45 that they are on a week 1 / month 1, it means that the tax code is no longer cumulative.
Let's see what happens to the above monthly employee who has been given a week 1 / month 1 tax code, 1257LX.
Month 1 - Employee earns £500. This is still below the monthly tax free allowance and so no tax is paid.
Month 2 - Employee earns £2000. But this time because the employee's tax code is not cumulative, the earnings in the previous month are not taken into account, nor is any tax free allowance not used in the previous month. This means that the calculation is £2000 - £1048 (month 2 tax free allowance only) = £952.
They will pay tax on £952, which is a lot more than if the employee had a cumulative tax code.
What do the other letters or tax codes mean?
The employee has a N tax code
This is the marriage allowance code. This means the employee has given 10% of their tax free allowance to their partner and therefore their tax free allowance will be reduced.
The employee has a M tax code
They have received 10% to be added to their tax free allowance and therefore their tax free allowance will be increased.
The employee has a T tax code
This means the employee's tax code has been worked out with other calculations - for example, the employee may have another job and so the tax code might be split between the jobs.
The employee has a 0T tax code
This could mean the employee has used up all their tax free allowance or the employee starts a new job but the employer does not have the correct information to apply a tax code.
The employee has a BR tax code
This could mean that all earnings from this employment are taxed at the basic rate because the employee has more than one job or pension.
The employee has a D0 tax code
This could mean that all earnings from this employment are taxed at the higher rate because the employee has more than one job or pension.
The employee has a D1 tax code
This could mean that all earnings from this employment are taxed at the additional rate because the employee has more than one job or pension.
The employee has a NT tax code
The employee is paying no tax on earnings in the employment.
The employee has a K at the front of the tax code
This means that the employee has no tax-free allowance and may pay higher tax in this employment. No more than 50% of pre-tax earnings or pension can be deducted.
For more information on the different codes for employees, HMRC have a helpful guide under Income tax - Tax codes.