Dangerous letters to watch for on your HMRC tax code

Tax experts have shed light on the significance of the collection of letters and numbers issued to you by HMRC - and the importance of ensuring its accuracy. Failure to do so could result in paying up to 60% tax on your salary, warns Sarah Hollowell, Head of Tax and Trustee Services at Killik and Co.

Paying the correct amount of tax is vital for maintaining your financial health and avoiding any unexpected bills from HMRC. Making sure your tax code is accurate and up to date is a crucial step in this process.

This guide can assist you in checking and, if necessary, correcting your tax code.

HMRC issues a tax code to everyone on the Pay As You Earn (PAYE) system. This informs your employer or pension provider how much tax to deduct from your wages or pension.

The PAYE system allows HMRC to collect your income tax and national insurance directly from your pay on an ongoing basis, unlike the annual tax return system used in the US and France, reports Wales Online.

Both part- and full-time workers, as well as those receiving a private pension, will have a tax code. If you are fully self-employed, you will not have a tax code, as all your income is taxed through self-assessment, which you need to submit yourself.

Understand and check your tax code.

Your tax code, a mix of numbers and letters, indicates (a) reliefs and/or allowances that lower your taxable amount and (b) restrictions or other income that increase your taxable amount. To calculate the tax code, restrictions are subtracted from allowances, resulting in the amount you're exempt from tax on during the year.

The standard tax-free personal allowance is £12,570. Therefore, if you have no other allowances or restrictions, you would be issued a tax code of 1257L, which means you can earn up to £12,570 before being taxed.

Your personal allowance may be adjusted if your income surpasses £100,000, including benefits in kind from your employer. Other allowances or reliefs could include charitable donations and pension contributions.

PAYE code restrictions might be used to reclaim underpaid tax from a previous year or to collect tax on a separate income source (like tax due on interest or the state pension), especially when the taxpayer doesn't need to file a tax return.

If the restrictions exceed the allowances, an amount will be added to your pay to determine how much tax should be deducted. In this case, your code will start with the letter K.

Other letters in the code indicate specific circumstances; for example, 'L' signifies you are entitled to the standard personal allowance and is the most common code. If you have more than one source of PAYE income, you might see the codes BR meaning the whole amount will be taxed at the basic rate, or D0 which is similar but collects tax at the higher rate.

There are several others; an explanation of these may all be found online.

Your tax code can be found on your payslip, P45 (the form you get from your employer when you leave your job), P60 (annual tax review from your employer), your pension advice slip, from the HR department at work, or on a tax code notice letter from HMRC (if you get one). You can also set up an online Personal Tax Account which offers a convenient way to monitor and update your tax details.

Through this, you can ensure all your personal details are up to date and report any changes in your circumstances to ensure your tax code remains accurate.

Another way to check and monitor your tax code is to review your payslip each month. Make it a habit to confirm that the correct amount of tax is being deducted, and be sure to contact HMRC if you spot any discrepancies.

Keep an eye on bonuses and the 60% tax trap.

If you are due to receive a bonus or other one-off payment, it's important that you consider how this might affect your tax code.

Under the existing code system, an employee's annual salary is calculated based on the information provided each month. This means that if a worker receives a bonus, leading to an unusually high monthly income, HMRC's systems may interpret this as 1/12th of their yearly salary and could potentially issue a new tax code under the assumption of increased pay.

The effect of this largely depends on the individual's initial salary and the size of their bonus. In essence, if your total monthly earnings suggest an annual income of £100,000 or more, you might find yourself paying an effective tax rate of 60% on your income.

This is due to the 'personal allowance taper' which comes into play once an individual earns over £100,000. For every £2 earned above this threshold, the personal allowance is reduced by £1, meaning that once you earn £125,140 or more, your allowance is completely eliminated.

Consequently, a one-off bonus could distort HMRC's perception of your annual salary, leading them to issue an incorrect tax code. If you suspect this might affect you, it's crucial to scrutinise any new tax codes received and report any discrepancies to HMRC to avoid overpaying tax.

Understanding your tax code, regularly reviewing your payslip, and promptly informing HMRC of any changes or potential errors can ensure you're paying the correct amount of tax. If you're uncertain about your current situation and need more detailed advice, it's advisable to consult a financial advisor.

This can help you manage your finances effectively and avoid any unexpected shocks from HMRC.