Pay As You Earn in the system used by employers to deduct your income tax and National Insurance liability before they pay your wages to you.
Income Tax is cumulative, so this means that all income throughout the year must be added together to calculate your tax liability and then HMRC try to ensure that the correct tax is taken throughout the year. If this doesn’t happen then HMRC will assess any under or over payment once the tax year has ended. For this reason it is important that you understand your tax code and ensure that it is correct throughout the year.
HMRC will issue your employer with a tax code and this will tell them how much tax they should deduct from your pay.
Employers notify HMRC each time that they make a payment to you as well as how much tax and National Insurance has been deducted. At the end of the tax year, your employer will give you a P60 which is a summary of the total pay that you have received throughout the tax year as well as how much tax you have paid. If you leave your employment during the tax year, your employer will give you a P45 which is a summary of your pay received so far during the tax year; if you start a new job, you should give your new employer the P45 and this will ensure that your total tax paid throughout the tax year is all correct. Your personal allowance will be applied equally throughout the tax year and therefore if you switch employers, your P45 will ensure that you do not under or over pay tax during the change of payrolls.
Sometimes your employer may be unable to calculate your tax liability on a cumulative basis, for example, if they do not know how much other income you have received in the tax year. In this instance, your employer will need to calculate your tax liability for each period in isolation, ie, with no reference to the rest of the tax year. You can tell if this is happening as your tax code will have a W1 M1 or X at the end, this is because it is known as Week One/Month One basis. If this happens then it is important to ensure that your tax is correct for the overall year.
For many employees, your tax code will represent your personal allowance and you should receive a letter from HMRC to explain how it is calculated. In some instances your code may be updated:
- if you start to get income from an additional job or pension
- you or your employer tells HMRC that you have started or stopped getting benefits from your job
- you receive taxable state benefits
- you claim Marriage Allowance
- you pay expenses related to your job
- you make donations to charity through Gift Aid
- you make private pension contributions directly to a qualifying pension scheme
- you receive Child Benefit and earn over the threshold for the High Income Child Benefit Charge
Self Assessment Tax Returns is a different system used to calculate your Tax and National Insurance liability, this can be because your income isn’t taxed at source, for example, by an employer or because you income is more complex or you are self employed.
It is important to note that whilst there are mechanisms in place to allow transfer of liability between the two systems, they are essentially two entirely different systems with not much interaction. This makes it important that you clearly understand your liabilities and which system they are being paid under to avoid confusion. For example when you are completing your self assessment tax return, it is important to include any adjustments that have been made under the PAYE system, such as adjustment to tax code to collect underpaid tax, otherwise the calculation will not take this into account. Similarly, when completing your self assessment tax return, if you elect to have your tax collected via your tax code, it is important that the information is carried forward otherwise the liability could potentially keep passing between PAYE and Self Assessment system and will simply accrue without being paid.