Isn’t it crazy that we are taught nothing in schools about our income tax? We are supposed to just start working, knowing exactly how much we should be paying and nodding our heads when asked to fill out a P46 and stare dumbfoundly when opening our P60s with no idea what it all really means! Or at least that’s what I was like until my dad, who is an accountant, sat me down and explained it to me. So here is my Q & A post on what I think everyone should understand about their taxes.
1. What is income tax?
Fairly simple really; it is simply the money we have to give to the government out of our earnings.
2. What is National Insurance Contribution or NI tax?
Historically, this was the contribution everyone had to give from their earnings to go into a big pot that helped to pay for the NHS and for our pensions. The historical nature of the NI tax has predominantly disappeared and it now all just goes into the same pot, and really it is just another form of income tax that everyone has to pay. However, one thing that does remain is that in order for a person to receive a full state pension, they must have contributed their NI tax for at least 30 years.
3. When do I have to start paying my income tax?
You start paying income tax after you have earned over your tax-free allowance. You find out your tax-free allowance when you are issued a tax code, and this will be issued to you after the age of 16. Most people are issued a standard 944L code, and this will only be different under specific circumstances, such as: having more than one job, being a pensioner, or earning taxable benefits from an employer, for example a company car. Additionally, most state benefits are taxable as income. You can find more about taxable benefits on the HMRC website here.
However, if none of the above apply to you, then you should be issued the standard 944L tax code.
4. What does the tax code 944L mean?
If you take the number before the letter ‘L’ and add a zero to it, then there you have your tax-free allowance. So 944L means that within the tax year (April 6th – April 5th) you can earn up to £9440 without being taxed. Anything that you earn over that amount is taxable. Therefore, if you earn £10,000 a year, then in that year you will be taxed on £560.
5. How much tax do I have to pay?
You will pay the basic tax rate which is currently 20%. If you earned £10,000 in a year, then you will have to pay 20% of your taxable income, which we figured out above is £560, therefore you will have to pay £112 for the year.
6. When do I have to pay this?
The way that the tax system works is that your taxes are figured out depending on how you are paid. For example, if you are paid once every month, and your tax code is 944L, then every month you have a tax-free allowance of 1/12 of £9440, which is £786.67. So let’s say again that you are earning £10,000 per year, then each month you earn £833.33. If you take away your tax-free allowance from this amount, you are left with £46.66 and that amount alone is what you will be taxed on every month. Therefore, you should pay £9.33 tax every month. If you times this by 12, then you are left with £112, which is what we figured out to be the amount of tax you should pay for the entire year.
7. What if I change jobs and start earning more money?
This simply means that every month after the start of your new job the amount you earn above your tax-free allowance will be more, therefore you will have to pay more tax. However, taxes work on a cumulative basis, so at the end of the year it will work out that you have paid the correct amount. Okay, so let’s assume that you have been working in a job where you were earning £10,000 per year for 6 months, and then you moved to a new job where you were earning £15,000 per year for the last six months. We know that in the first sixth months you will have earned 6 x £833.33 which is £4999.98 and your tax free allowance for the six months will have been £4720.02. You will have had to pay tax on the difference, which is £279.96, therefore you will have paid £55.99. So for the next sixth months you are earning £15,000 per year, which works out as £1250 per month. Now this is £463.33 more than your tax free allowance and therefore you will get taxed on that amount, which works out as £92.67 tax per month. So at the end of the year you will have paid £611.99 tax. Over the year you will have earned £12,499.98, which is £3059.98 more than your tax-free allowance, and therefore the amount you should have paid tax on in the year. If you figure it out, 20% of £3059.98 does work out to be £611.99
8. What if I am issued the wrong tax code?
If you think that you are paying too much tax, then the chances are it is because you have been issued with the wrong tax code. Unless you have specific circumstances, the chances are that if your tax code is not 944L, then it is wrong. What you need to do is call up HMRC and inform them that you think your tax code is wrong. This could be simply an error and they will issue you with the correct tax code, which will in turn be sent to your employer. What happens next is that your employer will input your correct tax code, and from that will look at the cumulative amount of tax that you have paid throughout the year. So let’s say you are currently earning £12,000 per year and you are paid monthly, and in error you have been issued with a tax code 500L. This would mean that instead of having £9440 tax-free allowance per year, you are only being allowed £5000 tax-free. This has been going on for 2 months, so each month you have earned £1000. After dividing £9440 by 12 you can see that on the 944L tax code you can earn £786.67 per month tax free, meaning only £213.33 would be taxed per month at 20%. However, if you divide £5000 by 12 you can see that only £416.67 of your income is tax free per month, meaning you would be taxed at 20% on £583.33 each month. Therefore, for those two months you would have paid £116.67 tax when you should have only paid £42.67. At this point you would need to contact HMRC and request a new, correct tax code to be sent to yourself and to your employer. Once your employer gets your new tax code, the system looks back at your cumulative income and your cumulative taxes, so in month three it will see that you have earned £2000, of which £426.67 is taxable. It will then show that you have paid £233.34 instead of £85.34 in taxes. For month three it will work out that you will have earned £3000 and should have, by that point, paid £128.01 in taxes. From seeing that you have in fact paid £233.34 you will receive a refund in that payslip to the extra amount that you have paid, which at that point will be £105.33. From then on you will continue to be taxed correctly and it will have figured itself out.
9. What if I do not realize that I have been issued with the wrong tax code, how will I get my refund?
In this case what will happen is that at the end of the tax year your employer will issue you with a P60, and on there will be all of the information regarding your cumulative income and cumulative tax paid. HMRC will receive this and if the amount you have paid is incorrect due to an incorrect tax code, you will be issued with the correct tax code and a figure will be calculated for the year of how much extra tax you have paid. HMRC will then send this to you in a cheque.
10. What is a P45?
This is given to you when you leave a job by your employer, and it gives a summary of your cumulative income from them within that tax year, and the amount of tax you have paid. It is very important you get your P45 as quickly as possible from your ex-employer to give to your new employer to ensure your new employer issues you with the correct tax code.
11. What happens if I start a new job and have not got a P45 to give to my new employer?
The chances are you will be put on emergency tax. This is an assumption by your new employer that you are on the standard 944L tax code, but it is on a month one basis (if you get paid monthly; if you are paid weekly, it will be week 1 basis). This just means that, until your employer receives your correct tax code and has a summary of your cumulative income, then your taxes are calculated on a monthly basis. Therefore, every month you will be taxed on the amount that you earn that is more than your monthly tax-free allowance, without looking back on what you have paid in previous months.
12. Why does it matter if I am on a month 1 tax code?
Let’s just imagine that for the first sixth months of the year you are working part-time and only earning £500 per month; then you get a new full-time job earning £1000 per month. We figured out that on 944L you are entitled to £786.67 tax-free income per month, so when you get your new job you will be taxed on £213.33 per month, which works out as £42.67 per month. Therefore, for those last six months where you earn £1000 per month, you will have paid £256.00 in taxes. However, if you look at it cumulatively, in the first six months you only earned £3000 and in the next sixth months you earned £6000 and therefore for the entire year you only actually earned £9000, and you are entitled to £9440 tax-free income. Therefore, you will have been paying taxes for those last six months when you shouldn’t have been.
13. How do I avoid being put on emergency tax?
If you give your new employer a P45 straight away, then they will be able to transfer all of your tax information and your correct tax code. If you cannot get a P45, then you need to get a P46 from your new employer. This is basically your declaration to HMRC that you no longer work for the previous company, and a request for them to send your new employer your correct tax code.
ONE FINAL NOTE TO BE AWARE OF
I feel I have to mention this, as I have fallen into this trap. If you are employed by more than one temporary work agency, then HMRC will assume that you have more than one income. If you do not declare to them how much you are earning, then you may end up being taxed at a higher rate, such as 40%. Even if you have only done ONE DAY’S WORK for one of the agencies. So just be very careful if working in more than one place; otherwise you may end up coughing up a lot of money and it could potentially take a very long time for it to get sorted out.