The letters in an employee’s tax code signify their entitlement (or not) to the annual tax free personal allowance. The tax codes are updated annually, or when an employee’s circumstances change, and help employers work out how much tax to deduct from an employee’s pay packet.
The basic personal allowance for the tax year starting 6 April 2017 is £11,500 and the tax code for an employee entitled to the standard tax-free Personal Allowance 1150L. This is the most common tax code and is used for most people with one job and no untaxed income, unpaid tax or taxable benefits (for example a company car).
There are also emergency tax codes which may be used if a new employee doesn’t have a P45. These codes mean that an employee’s tax calculation is based solely on what they are paid in the current pay period.
A ‘K’ tax code is seen less often and is used when deductions due for company benefits, state pension or tax owed from previous years are greater than an employee’s personal allowance. Employees need to multiply the number in the employee’s tax code by 10 to show how much should be added to their taxable income before deductions are calculated.
In order to cap HMRC’s enthusiasm for restricting allowances to recover unpaid tax, an employee’s tax deductions for each pay period can’t be more than half their pre-tax pay or pension.