An explanation of PAYE coding notices

Employees and employers receive periodic updates to tax code numbers. This number is used by your employer/pension provider to calculate the amount of tax you are stopped on your salary and/or pension.

If your affairs are straight forward (and you are not able to claim certain age related allowances) you are entitled to earn the first £5,225 of your income in 2007-2008, tax free. If this were the case your code number would be 522L.

If your code number drops, to say 200L, you will pay more tax each pay period. If the tax code increases, you will pay less tax. (But see note on K codes below.)

We have listed below a number of generalised factors that may affect your code number. The list is not comprehensive so do contact us if you receive a code number adjustment that is difficult to understand.

1. Reduction for unpaid tax in earlier years. If you had underpaid tax in the tax year to 5 April 2006 by say £500 the Revenue will allow you, in certain circumstances, to pay the tax back in a following tax year. To facilitate this, the Revenue will deduct an amount from your tax code. For instance if you are a standard rate tax payer, currently 22%, your tax allowances would need to be reduced by £2,272 to effectively recover the £500 you owe. (For those of you who like to see the maths this is calculated by dividing £500 by 22 and multiplying the result by 100 = £2,272). On your notice of coding you would see a reduction in your code number from say 522L to 295L. (522-227).

2. Reduction for benefits provided by employer. If your employer provides you with a company car, or private medical insurance, or indeed any other form of benefit, without an adjustment to your tax code you would always owe the Revenue the tax on the benefit at the end of each tax year. So that this does not happen your code number will be reduced accordingly. The reduction works by deducting the value of the benefit from your code; thus a benefit of £500 will result in a reduction in your code number of £500, i.e. 50 points.

3. Reduction for higher rate tax payers. If your earnings are part subject to tax at 40%, and they include significant interest received or dividend income, you will owe the higher rate tax on your investment income at the end of the tax year. To counter this the estimated higher rate tax on your non-salaried/pensionable income will be recovered by reducing your tax code. As your interest and dividends received are taxed at the basic rate, only the marginal increase above the tax already deducted will be taken into account.

What happens if the reduction in your code number is more than your present code?

K Codes – If your tax free allowance of £5,225 is reduced by £2,272, as in example 1 above, you will still have a positive tax code of 295L. If however the deduction from your tax allowance is £10,000 you will have changed a positive tax free deduction of £5,225 into a negative position of -£4,775. This “negative deduction” is actually taxable income. Instead of receiving a tax free allowance of £5,225 you are being taxed on additional income of £4,775.

Your tax code could be changed from 522L to -477L. In their wisdom the Revenue have chosen to display -477L as K477. When you see a tax code prefixed by the letter “K” add on a zero and this is the equivalent income being added to your tax assessment for the year. The larger the K code, the more tax you will pay – although the revenue cannot take more than 50% of your salary in tax in this way!

One Response to this post.

  1. Posted by Bronwyn on 25.02.08 at 5:42 pm

    Thank you – I found this explanation extremely helpful. When I phoned HM Revenue & Customs to ask for an explanation of my K tax code I was basically told that they understand what to do and I don’t need to!

    My query was why an amount of unpaid tax of £778 was converted into £3116 (again, he said to ignore the £ sign, that shouldn’t be there!).

    You’ve made it very clear.

    Best
    Bronwyn

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