As a taxpayer, it is vital to understand tax codes as they have a significant impact on how much you pay in taxes. Tax codes refer to a set of rules and regulations that determine how the government computes and collects taxes. The tax codes in your country determine what expenses you can claim back from the government, what deductions you can make on your tax payments, and what taxes you are liable to pay. In this article, we will delve into everything you need to know about tax codes.
What Are Tax Codes?
A tax code is essentially a code that is used by the government to determine the amount of tax that an individual or business should pay. These codes are made up of a series of letters and numbers that are used by the HM Revenue and Customs (HMRC) to calculate the amount of Tax paid by a tax payer. The tax codes used by the HMRC will differ depending on factors such as an individual’s salary, pension, and employment benefits.
In the UK, tax codes consist of a series of numbers and letters, and they are usually made up of three main elements. The first element is a number that indicates the amount of the personal allowance that an individual is entitled to; this is the amount of earnings that are tax-free during a tax year. The second element is a letter that indicates what type of taxpayer you are, for example, an individual with one job, a pensioner, or someone with more than one job or pension. Lastly, the third element is another number that shows any additional requirements or restrictions that apply to your personal allowance.
Tax Codes and Personal Allowances
Personal allowances are the earnings that are exempted from taxes on an annual basis. The amount of personal allowance varies depending on different factors such as age, income, and your residency status. Personal allowances are automatically factored into your tax code and go towards reducing the amount of tax you have to pay during the year. In the last budget announcement, there were updates on personal allowance increases for the tax year 2021-2022 in the UK. The personal allowance for individuals is £12,570 and £13,430 for individuals who are aged 75 years or over.
Broken down, this means that you can earn £12,570 as a tax-free allowance, thus avoiding tax payments on your earnings up to that amount. If you earn above that amount, then you will be required to pay taxes on that amount at the tax rate applied to your taxable income. Your tax code determines your personal allowance, and it is the responsibility of the employer to ensure that the correct code is applied.
Understanding Tax Rates
After your personal allowance has been factored in, the next step is to calculate how much tax you owe based on your earnings. Tax rates vary depending on how much you earn. In the UK, there are three main tax bands that are based on an individual’s earnings. The basic rate for individuals earning up to £37,500, the higher rate for those earning between £37,501 and £150,000, and the additional rate for those earning over £150,000. As of the 6th of April 2021, the basic rate for tax is 20%, the higher rate is 40%, and the additional rate is 45%.
Your tax code determines which tax rate will apply to your income. To ensure that you are paying the correct amount of tax, it is essential to understand your tax code, especially if you have multiple sources of income. In the UK, the tax code applied to your primary source of income is usually given to your employer. If you have a secondary source of income, you may need to inform your employer or your pension fund provider of your total earnings to ensure they apply the correct tax code.
Changes to Your Tax Code
Your tax code may change during the year for a variety of reasons. Some of these reasons include changes to your personal allowance, changes to your income, or changes to the tax bands. For example, if you start receiving the State Pension or any personal pension during the tax year, this may result in a change in your tax code.
If your tax code has changed, it is essential to understand the reason behind the change to avoid being under or overtaxed. If your tax code is incorrect, you may need to contact the HMRC or your employer to have it corrected. Errors in your tax code can result in heavy penalties and interests, especially if the matter is not resolved soon.
Tax Codes and Benefits
Understanding your tax code is not only crucial to ensure you are paying the correct amount of taxes, but it is also essential if you are eligible for any tax credits or benefits. Tax codes are used by the government to determine eligibility for certain benefits such as Child Tax Credit, Working Tax Credit, and State Pension. Your tax code determines how much tax you owe, which is then used to calculate the amount of benefit you are entitled to receive.
In the UK, the government has updated the tax credits system in recent years by replacing it with Universal Credit. Universal Credit is a single monthly payment that simplifies the tax credit system and aims to ensure that those who are eligible receive the appropriate amount of benefit.
Tax Codes and Self Employed Individuals
If you are self-employed, you are responsible for calculating and paying your own taxes. Self-employed individuals have their unique tax codes known as Unique Taxpayer Reference (UTR), which are given to them by the HMRC. The UTR is a 10-digit number that is used by the HMRC to identify each self-employed person and is essential for filing tax returns, making payments, and communicating with the HMRC.
As a self-employed person, you will need to keep accurate records of your earnings and expenses to calculate the amount of tax you owe. You are also responsible for filing tax returns and making tax payments on time. Failure to comply with your tax obligations can result in hefty penalties and interests. Keeping track of your tax code, understanding it and keeping records up to date, is vital in ensuring that you are paying the correct amount of tax and avoiding penalties.
The Bottom Line
Understanding your tax code is essential in ensuring that you are paying the correct amount of taxes, are eligible for tax credits or benefits, and are not at risk of incurring penalties and interests. Tax codes are complex, and it is essential to stay updated with any changes to the regulations that may affect your tax obligations. Keep accurate records, understand the tax bands and rates, and notify the HMRC in case of any discrepancies in your tax codes. With this information at hand, you can reduce your tax obligations, stay compliant with the tax laws and avoid penalties and interests.
A tax code is something an employer may use to help calculate the amount of taxes to deduct from an employees paycheck. Improper coding can cause a person to be taxed too little or too much.
Generally tax codes are consisting of numbers and letters which can symbolize different things. Here are common uses for some letters found in tax codes:
L- eligible for basic personal allowance
P- people who are 65-74 years old and are eligible for full personal allowance
Y- people who are 75 years or old and are eligible for full personal allowance
Some people may see a tax code which is strictly letters. These tax codes, such as BR, D0, or NT also help the employer to tax a person correctly. If a person sees the tax code BR all of their income is taxed at a basic rate. If a person sees a tax code of D0 their income is taxed at a higher rate. Lastly, if a person sees a tax code of NT no taxes will be taken.
Tax codes may need to be changed by an employer if an employee undergoes a circumstance in which their taxation would be effected. Things that may affect a tax code can include marriage or divorce, a second income, or a change in pay. By law, an employer must make not of any changes and update all tax codes if a change does occur.
If an employee is taxed improperly due to an improper tax code on the employers end, then the employer must refund the employee the money that has been taken from them.
