How do I explain income tax to my employees?

UK earners that are employees and paid via a company payroll system are generally familiar with the words ‘income tax,’ but some employees don’t understand what it means, what it’s used for, how it’s worked out or what to do if it’s wrong. 

In this handy guide for employers, we’ll break down how to explain income tax to employees. 

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What is income tax used for?

Income tax is used for a variety of purposes, including:

- Funding public services: A significant portion of tax revenue goes towards funding public services such as healthcare, education, social care and public transportation 

- Defense and national security: Another significant portion of tax revenue is allocated to paying for defense and national security. This includes funding for the armed forces, intelligence agencies and for counter-terrorism efforts

- Maintaining public infrastructure: Tax revenue is used to maintain and improve public infrastructure, such as roads, bridges and public buildings

- Welfare programs: Tax revenue also funds a variety of welfare programs, including unemployment benefits, disability benefits and housing assistance

- Interest payments on national debt: The UK government also uses tax revenue to pay the interest on the national debt, which is the accumulated amount of money the government has borrowed over time

- International aid: A small portion of tax revenue is allocated towards providing international aid to developing countries and other areas in need, such as in the case of natural disasters or war

Overall, UK tax revenue is used to support a wide range of government services and programs, all aimed at promoting the wellbeing of citizens and the country.

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What are tax bands and thresholds for 2023/24?

The standard ‘Personal Allowance’ that an employee can earn without being taxed is £12,570 per year.  This is before any benefits or adjustments are made to income by the personal tax code, explained below. Once employees reach the ‘threshold’ of £12,570, the remaining income is taxed and, depending on how much they earn, the tax rates differ. When an employee is paid using the PAYE system - pay as you earn - income tax will automatically be deducted by the employer or outsourced payroll provider through their HMRC registered payroll software.

The ‘Personal Allowance’ changes every year and is set by the government, it can also differ from person to person based on an employee’s individual circumstances. This is managed by their personal tax code. The Personal Allowance will be broken down over the number of tax periods in a year based on the frequency the employee is paid.

• The basic rate of tax is 20% and this applies to earnings between £12,571 and £50,270 per year
• The higher rate of tax is 40% and applies to earnings between £50,271 and £125,140
• The additional rate of tax is 45% and applies to earnings over £125,140 per year

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Examples of tax due based on annual income:

What is a tax code?

Explaining tax to employees includes an explanation of the tax code. This is a combination of letters and numbers that HM Revenue and Customs (‘HMRC’) use to work out how much tax an employee should be paying. An employee’s tax code is usually based on how much they earn and whether they’re entitled to any tax-free allowances or are in receipt of benefits as part of their employment.

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What kind of benefits affect a tax code?

There are a variety of benefits that can affect a UK taxpayer's tax code. As an example, if a taxpayer receives taxable benefits such as a company car, private medical insurance or accommodation as part of their employment, it will reduce their personal tax-free earnings threshold from £12,570. This subsequently increases the amount of their income that’s going to be taxed. 

On the other hand, an employee’s personal allowance may be bigger if they claim marriage allowance or blind persons allowance. 

It’s important for taxpayers to stay informed about their benefits and how they impact their tax liability. It’s also important to disclose additional income or changes in circumstances to HMRC, so their tax code can be changed and the employee pays the correct level of income tax.

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How is an income tax code calculated?

Tax codes are calculated by HMRC, based on information provided by the employer or pension provider. It takes into account the employee’s personal allowance, any taxable benefits that they receive and any other income that they might have – such as a second job, pension payments or rental income. The tax code is designed to ensure that employees pay the correct amount of tax over the course of the tax year.

What do the letters in a tax code mean?

The letters in a tax code indicate an employee’s personal tax situation. The most common tax code letters and what they mean are: 

• L: The employee is entitled to the standard tax-free personal allowance
• M: The employee received a transfer of 10% of their partner's personal allowance
• N: The employee has transferred 10% of their personal allowance to their partner
• S: The employee has their main home in Scotland
• C: The employee has their main home in Wales
• T: The employee’s tax code includes some items being reviewed by HMRC
• K: The letter K is used in an employee’s tax code when deductions due for company benefits, state pension or tax owed from previous years are greater than their Personal Allowance

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What do the numbers in a tax code mean?

The numbers in a tax code indicate how much tax-free income an employee is entitled to in the tax year. An employee’s personal allowance for the year is divided by 10 and rounded down to the nearest £10. So, for example, if the personal allowance is £12,570, the tax code would be 1257L (the L indicating that the employee is entitled to the standard personal allowance).

The tax code number will be reduced if the employee receives benefits as part of their employment, such as private health care. The monetary value of the private health care benefit will be subtracted from the employee’s tax-free allowance, the employee would then start paying tax on more of their income.

For example, if the financial value of the private health care is £1000 per year, this value would be deducted from the tax-free allowance, reducing it from £12,570 per year to £11,570. 

The employee’s tax code would be changed to 1157L and the employee would start paying 20% tax on earnings between £11,570 and £50,270, instead of £12,570 to £50,270.  HMRC is usually notified of these types of benefits via form P11D submitted by their employer at the end of a previous tax year, alternatively if the employee knows the value of the benefit they can advise HMRC themselves.

HMRC looks at benefits provided by an employee and taxes the employee for those benefits, but it’s still cheaper than the employee paying for that benefit themself. 

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What if a tax code is wrong?

If you think an employee’s tax code is wrong, they should contact HMRC as soon as possible. HMRC can correct errors and ensure that the employee is paying the correct amount of tax. Employees should be encouraged to check their tax code regularly to make sure it's up to date and reflects their personal circumstances.

Employees should also be encouraged to report any changes in their personal circumstances to their employer as this may affect their tax code.

If a taxpayer has not declared some of their income or the tax code has been wrong and has not been corrected, HMRC has the power to change the employee’s tax code to recoup unpaid tax. This can happen if a taxpayer has underpaid tax in the previous tax year or has an outstanding tax debt.

HMRC will issue a notice of coding to the taxpayer or their employer, which will explain the changes to their tax code and the amount of tax that needs to be collected. The changes may result in an increase in the amount of tax deducted from the employee’s income, and this would reduce their take-home pay. 

In some cases, employees may be able to negotiate a payment plan with HMRC to spread the repayment of the unpaid tax over a longer period. Failure to pay the correct amount of tax can result in penalties, interest charges and legal action by HMRC.

In conclusion, UK tax codes can seem complicated, but they're quite straightforward. Once employees understand what the letters and numbers mean and have the income tax codes explained, it's much less daunting. Tax codes are designed to ensure that workers pay the correct amount of tax over the course of the year as their contribution to the cost of running the country and using services such as the NHS, education and public infrastructure. Combine having income tax explained and the benefits of employees having a better understanding of their payslips helps to increase comprehension leading to better financial wellness for employees.

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