What is PAYE and how is PAYE calculated?

PAYE, ‘Pay As You Earn,’ is a way of paying income tax directly at source.

Who pays PAYE?

PAYE is also a method to pay HMRC where the employer deducts the National Insurance (NI) and Income Tax due on an employee’s salary, before paying them their net wages.

Pay As You Earn is the way most people in the UK pay the tax due on their income. 

But here, exclusively for ContractorUK, I want to explain the PAYE process and how PAYE is calculated, as far as contractors and contractor sector employers are concerned, writes Christian Hickmott, managing director of Integro Accounting. 

PAYE and your tax code 

Once an employer has set you up on their payroll system, you’ll be allocated a tax code by HMRC. This code allocates a tax-free allowance for that tax year -- so you’ll only start paying tax on earnings over that figure. 

You’ll be issued your tax code at the beginning of the tax year, usually by post – but if you’ve registered with HMRC to view your personal tax account online, you’ll be able to log in and check your tax code for the current tax year. More details can be found here.

Your employer will also receive this code from HMRC, and you should also be able to see the code your employer is using for you on your payslip. 

How does HMRC work out my tax code? 

To work out your tax code, HMRC will always begin with the standard personal allowance (which is £12,570 for the tax year 2023/24), and then add items like regular pension contributions or employment-related expenses, while also making deductions for other income or taxes owed for a prior period.

In most cases, HMRC will then just knock the final number off and add the letter ‘L’. For example, a tax code of 1200L would mean that you can earn £12,000 of salary before any income tax is deducted. 

What does the letter in my tax code stand for?

The letter on the tax code represents your individual circumstance. For example, an ‘L’ would be for an individual that is entitled to the standard tax-free personal allowance, whereas an ‘M’ would be for an individual who has transferred some of their personal allowance. HMRC has explained the full list of these codes here. 

In some cases, you may get what is referred to as an ‘emergency tax code’. This usually means that either your employer does not know what your tax code is, or that your personal allowance has been allocated to another employment or pension. 

You may also receive a tax code that ends with a ‘T’. This means that your expected income for the year is above £100,000 and so your personal allowance has been ‘tapered.’ For example, someone who has a tax code of 657T, is expected to have income of £112,000 and so is only entitled to a personal allowance of £6,570. 

How to tell if HMRC allocated me the correct tax code? 

It's your responsibility to ensure you’re on the correct tax code, and if it’s incorrect you could be paying either too much or too little tax.

While the former could mean you might be due a tax rebate later down the line (if it’s spotted or rectified), the latter could see you faced with a nasty surprise in the form of an HMRC bill to pay at the end of the tax year.

If you’re unsure if you’ve been allocated the correct tax code, it’s advisable to speak with your accountant who’ll be able to explain this for you, and should also be able to change to the correct code on your behalf.  

National Insurance Contributions (NICs) 

National Insurance is much simpler as everybody is entitled to the same allowances, regardless of their income. The only difference being that those who have reached the state pension will not have to make any personal contributions. 

Otherwise, you will be entitled to £12,570 without any NICs being due, £37,700 which will be charged at 12.00%, with all earnings over this being charged at 2.00%. 

If you’re an employer, you will be required to pay employer NICs of 13.80% on any earnings an employee makes in excess of £9,100. However, small businesses may be able to mitigate their NICs by making use of the Employment Allowance. 

Employer PAYE responsibilities 

All employers are required to register for PAYE, which then allows them to file the necessary reports to HMRC each time they pay their employees. 

It’s then the employer’s responsibility to ensure the correct amounts of NI and Income Tax (using the tax code provided) are deducted from employee salaries, when the employer runs the payroll, and then pays HMRC. This can be done yourself as an employer (although it’s a time-consuming and complicated option), or by using a payroll software solution or an accountant with payroll services. 

In closing, a warning…

Depending on the amount of tax due, payments need to be made monthly or quarterly – monthly must be made to HMRC by the 22nd of the next tax month and if quarterly, by the 22nd after the end of the quarter. As with all taxes, failure to make payments on time will result in interest being charged and penalties being raised.