Understanding tax codes is essential for both employers and employees. This guide explains what tax codes mean, how they work, and what you need to know to keep your payroll on track.
What are tax codes, and why are they important?
A tax code combines numbers and letters that determine how much income tax should be taken from an individual’s salary or pension. This code represents the amount of tax-free income an individual gets in a given tax year (6 April – 5 April).
Tax codes help businesses calculate and withhold the correct amount of tax from employee wages. They provide information about an employee’s tax situation, including any allowances, benefits, or special circumstances that affect their tax liability.
Keeping up with employee tax codes can help ensure you comply with various tax regulations, including:
- PAYE (Pay As You Earn) regulations require employers to deduct income tax and National Insurance contributions from employee earnings before payment.
- RTI (Real Time Information) requirements outlined in Section 2a of The Income Tax (Pay As You Earn) Regulations 2003 (external link) mandate regular and accurate reporting of payroll information to HMRC.
- Tax code-specific regulations that may apply to special circumstances such as multiple employments (external link), benefits in kind (external link), and tax relief claims (external link).
Inaccuracies in tax returns and documents can trigger penalties (external link).
As well as staying compliant, keeping up with your tax codes can reduce the risk of underwithholding or overwithholding taxes:
- Underwithholding can leave employers and employees with unexpected tax bills at the end of the financial year
- Overwithholding unnecessarily shrinks employee take-home pay.
List of tax codes
The numbers represent the amount of tax-free income your employee earns in a tax year.
The letters indicate your employee’s specific tax situation.
The numbers show your employee’s tax-free personal allowance divided by 10.
For example, 1257L means your employee’s tax-free personal allowance is £12,570.
Basic letter codes:
- L: Standard personal allowance.
- M: Marriage allowance – you get 10% of your spouse’s allowance.
- N: Marriage allowance – you gave 10% of your allowance to your spouse.
- BR: Basic rate (20%).
- D0: Higher rate (40%).
- D1: Additional rate (45%).
Special circumstances:
- K: Your total allowances are less than your deductions.
- S: Your income is taxed under Scottish rates.
- C: Your income is taxed under Welsh rates
- T: Your tax code needs reviewing by HMRC.
- 0T: Your personal allowance has been used up.
- NT: No tax will be taken from your income.
Emergency codes:
W1, M1, or X: Emergency tax codes indicate your tax is calculated on a week 1 or month 1 basis, not cumulatively.
Your employee’s tax might change if their tax situation changes. For example, if they start a new job, receive new income, or claim new allowances or benefits.
What is an emergency tax code?
If someone’s tax code is incorrect, they might be given an emergency tax code.
An emergency tax code entitles individuals to the basic personal allowance, meaning they should pay tax on all their income above the basic personal allowance (£12,570).
It can happen when:
- Starting a new job
- Changing employment status
- Missing tax information.
If you’re on an emergency tax code, you might end up paying more tax than needed. Once HMRC has complete details, it will adjust the individual’s tax code and potentially refund overpaid tax.
What is tax code 1257L?
1257L is the most common tax code.
The numbers (1257) represent the individual’s annual tax-free income: £12,570.
The letter (L) indicates they are entitled to the standard tax-free Personal Allowance.
For example, if an employee earns £30,000 per year and has the tax code 1257L:
- They receive the standard tax-free allowance of £12,570.
- Only the remaining £17,430 is subject to income tax.
- They would pay the basic rate tax (20%) on this amount, which equals £3,486 in income tax.
How might tax codes affect small businesses differently from large businesses?
Tax codes can impact small businesses in various ways. They often operate with tighter cash flows, which can make them more sensitive to changes in tax obligations. This can affect their ability to reinvest profits, manage day-to-day expenses, and maintain financial stability. When tax regulations change, small businesses may need to adjust their financial plans more rapidly than larger companies with greater financial reserves.
Admin resources are another consideration. Small businesses typically have limited staff and resources dedicated to tax compliance. While large corporations often have specialised tax departments or hire accounting firms, small business owners might handle tax themselves or with minimal support. This can make staying up to date with tax code changes especially challenging.
How to check employee tax codes
Employee tax codes are found on several documents, making it relatively straightforward to find.
Employee tax codes can be found on their payslip, P45 form (if they’ve recently moved jobs), P60 annual tax summary, PAYE coding notice, or pension advice slip.
If you’re a business owner checking employee tax codes, this information should be stored on your payroll system or can be found in communications with HMRC.
If you still can’t confirm or locate an employee’s tax code, visit HMRC (external link).
Changing your tax code
If your tax code is incorrect, you could be paying too much or too little tax each month. If you want to check your tax code, you can use HMRC’s online service (external link).
Tax codes typically change at the start of the tax year, however your employee’s tax code may change during the tax year to reflect changes in their circumstances (for example, if they have a new source of income).
HMRC notifies employers when their employee’s tax codes change. Employers should not use a different employee tax code until notified by HMRC.1 (external link)
Changing your tax code
HMRC typically updates your tax code automatically when your circumstances change. However, if HMRC has any missing or incorrect information (for example, if you get company benefits or have alternative income that HMRC has not been informed of), you can update your information using the Check your Income Tax (external link)online service.
HMRC may change your tax code after receiving your updates.
Changing an employee’s tax code
Small business owners who manage payroll are advised to make tax code changes promptly upon receiving official notification from HMRC and before their next employee payment.
For more information, you can visit HMRC’s guide to understanding your employee’s tax codes (external link).
For guidance as to your specific tax circumstances, please consult a qualified tax professional for assistance.
Disclaimer:
At Hiscox, we want to help your small business thrive. Our blog has many articles you may find useful as you navigate your business tax obligations. But these articles aren’t professional tax advice and should not be relied upon as such. Tax laws are complex, frequently changing, and can vary by individual circumstances. So, to find out more about a subject we cover here, please seek professional tax assistance.
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