For anyone in employment, you might have noticed a tax code on your payslip, most commonly 1150L. But what does this actually mean?
Your tax code determines the allocation of your personal allowance against your income from that job. If you only have one job you will likely have 1150L tax code which means the full personal allowance, currently £11,500, is set against your income from that employment. However if you have multiple jobs you may have part of your allowance allocated to each or all to one and a code of BR or D0 on the others. BR means you pay basic rate tax, 20%, on all income from that employment and D0 means higher rate tax 40%.
HMRC may decide to restrict your tax code as a mechanism to collect tax that is owed from previous periods or will likely be owed in the future. This could be due to you having income from other sources or receiving taxable benefits. If HMRC restrict your tax code then you will be taxed on more of your employment income.
Tax codes work in one of two ways. The usual is on a cumulative basis, whereby the allowance is applied on a cumulative average throughout the year. If your income drops, this will bring your average for the year to date down and result in a refund of some of the tax you paid in earlier months. Likewise if your income increases, you will be charged extra to top up previous months. The cumulative tax codes makes sure that you will have paid the right amount of tax for the year to date based on your previous employment earnings.
The other method HMRC uses is to split your personal allowance into a twelve (if paid monthly) and to tax each period separately, without giving any consideration to what have been paid previous. These are often referred to as emergency tax codes and are followed by w1m1 (Week 1 Month 1). These types of tax codes are commonly used when starting a new job part way through a tax year which a P45 (joining form) has not been provided to the employer.
For more information on tax codes including what to do if you thing yours is wrong, please see HMRC’s website here.