In the UK, all income and benefits you from your employer is subject to income tax collected by HMRC. Income tax is usually calculated and deducted as PAYE from gross salary based on an employee's tax code and the amount of income.
What is an HMRC tax code?
An employer uses tax codes to determine how much income tax to deduct from gross pay. The tax code indicates the amount of tax free allowance an employee has for the tax year plus a letter as an identifier how the tax code is applied
1257L tax code: The standard tax code for 2022/23
In 2022, the standard tax code is based on the UK personal income tax free allowance of £12,570 per year, which means that the most common and standard tax code is 1257L, made up of the tax free allowance for the tax year divided by 10 plus the letter suffix L, which indicates that you are under 65 and eligible for the standard tax-free personal allowance
For example, if an employee earns £37,000 per year, they will only pay tax for £24,430 if their tax code is 1257L, and they will pay tax on £27,000 if their tax code is 1000L.
BR tax code: The base rate tax code
The tax code BR means Basic Rate and results in all income getting taxed at the basic tax rate of 20%. This tax code is usually applied in the case where an employee has another job or switches jobs in the middle of the tax year and does not provide information about its tax status to its employer.
0T tax code: The emergency tax code
The tax code 0T is an emergency tax code which results in the highest possible amount of tax being paid on all income. The 0 indicates that no tax free allowance is applied and T means that all taxable income is subject to the highest tax rate of 45%. This tax code is highly punitive to the employee and should be avoided to be used unless it reflects the actual situation of the employee, who in this is typically a high earner and has another job.
How do tax code changes work?
Normally at the start of the year, every employee gets assigned a new tax code based on the latest tax free allowance, adjusted for any over- or underpayments in the past tax year that is being rolled over into the new tax year.
If HMRC notices throughout the tax year that someone has been overpaying or underpaying tax, it adjusts the tax code accordingly so that by the end of the year the difference ends up to be 0, and sends a tax code change notice to their employer, which needs to be reflected in its payroll system.
Two methods to implement a tax code change
There are two ways how income tax can be calculated. the regular method is cumulative but under certain circumstances when cumulative is not possible due to lack of information, it can be calculated on a per-month / per-week basis, which is called the Month 1 or Week 1 method.
Cumulative tax method
Income tax (PAYE) is normally calculated on a cumulative basis. This means that you progressively earn your tax free allowance as the year progresses, and pay income tax taking into account your year-to-date figures for income, tax paid and allowance earned:
+ (income received YTD - allowance earned YTD) * tax rate
- income tax paid YTD
= income tax payable
If you are on a monthly pay period, you earn 1/12 of your annual tax allowance per month. That means if you are getting paid in August 2022 and have a tax code 1257L, you have a monthly allowance of £1,048 and have earned 5/12 of your annual allowance, i.e. £5,238. Keep in mind that the tax year starts in April.
If you are on this method and your tax code changes during the year, prior months are impacted too, because a different tax code was in place at the time. This means that in the month of the tax code change you will make up for or get back any difference in income tax you would have paid if you had been on this new tax code at the start of the year.
For example, if your tax code changed from 1257L to 1000L (cumulative) in August 2022, not only will you now pay more taxes for the month of August based on the lower monthly allowance of £833 but you will repay taxes on the difference in tax free allowance in the 4 months prior to August, i.e. 4 x (£1,048-£833) = £859, which at a base tax rate of 20% means an additional £172 in PAYE.
As a result your PAYE deduction on your August payslip will be £172 higher than going forward for the remaining months of the year.
Week 1/Month 1 method
There are some employees who have the Week 1/Month 1 settings attached to their tax code (usually marked by the M suffix). This means that their payments will be taxed as if it was the first week/month of the financial year, without taking into account the contributions made earlier in the year.
This setting is mainly used to prevent heavy deductions or giving refunds in case an employee has underpaid or overpaid tax to that point during the financial year.
For example, if the employee has underpaid their tax and they have the Week1/Month1 setting added to their tax code, that means that they will pay the remaining tax difference spread across the remaining months in the financial year.
If the employee has overpaid tax and they have the Week1/Month1 setting added to their tax code, they will deduct less tax for the remaining of the tax year so you earn back gradually what you have overpaid. This differs from the cumulative method, where the difference would be paid back in one go.
What if I have a wrong tax code?
If you have over-or underpaid income tax, HMRC will let your employer know automatically, who will then update their payroll system to collect or reimbursed the differential in future payruns.
How to change tax code
Incorrect tax codes can be easily updated and corrected in your employer's payroll system at any point in time. Using a tax code change as described above results in any amount of taxes over- or underpaid being returned or collected in future pay period, either in one go (cumulative method) or spread out across the remainder of the year (Month 1).
Why has my tax code changed?
Tax codes change normally at the beginning of the year if the government has changes the personal allowance which you can earn without paying any income tax in the tax year. For example, the personal allowance has increased from 1250L in tax year 2021/22 to 1257L in tax year 2022/23, resulting in the standard tax code change from 1250L to 1257L.
Tax codes can also change when HMRC realises that you have over- or underpaid tax , in which cases it adjusts the tax code in a way so that the difference is evened out by the end of the tax year, and informs your employer about the change using a tax coding notice.